As we discussed in my previous post, cryptocurrency exchange platforms have become more accessible, with the entry barrier, especially for retail investors, at an all-time low. Individuals with minimal investment experience are flooding into the crypto market, fuelling exponential growth. This new investor profile is entering a market characterised by little regulation, information asymmetry and excessive volatility. The resultant friction is an impetus for irrational behaviour in cryptocurrency investment.
Despite thinking that I was prepared to enter this world in a rational frame of mind as a result of what I thought was good research at the time. I’m not too proud to admit that I bought crypto at its peak last year, only to lose half of my investment shortly after. I’ve also made several other poor choices, such as going on a hike in the rain with terrible footwear. After all, isn’t it human to make bad decisions out of overconfidence?
When it comes to investments, however, we want to avoid the common pitfalls of human behaviour. To save on processing power, the brain uses shortcuts called heuristics. Using “a rule of thumb” approach speeds up the decision-making process but impairs reasoning. Our brains are excellent at conserving energy. That is why shortcuts are used, such as suppressing visual input or forgetting the page you just read. This is why we sometimes have difficulty processing information accurately.
Many of these cognitive biases also have an impact on our financial decisions. The psychological profile of an investor dictates how information is processed, what is prioritised, and, ultimately, what has the most impact on their behaviour. There is a field of study dedicated to this called behavioural finance, which explores the impact of psychology on the decision-making process of investors.
Therefore, it’s useful to approach investing by consciously breaking away from “mental shortcuts”. Ironically, we’ll be attempting to outwit our brain’s regular problem-solving abilities. This is easier said than done because even the most astute among us will misjudge the likelihood of events occurring or succumb to these biases. However, understanding these biases, developing a sense of perspective and applying basic guidelines to improve our decision-making could keep your portfolio above water.
1. Confirmation Bias
We all enjoy reading or hearing things that confirm our own opinions and beliefs. Social media, for example, has become a fertile ground for the spread of misleading information. Catchy headlines are frequently used to draw attention to baseless claims. There are news articles that claim to be “facts,” but are actually biased viewpoints that align with the reader. Any evidence presented in opposition to their position is either overlooked or filtered out. We will repeatedly seek the pleasant solace of confirmation bias.
Hopium, a phrase popular in the crypto community, is nothing more than a false impression of hope based on nothing. It includes claims like “Luna Classic to $1 this year.” Oftentimes, people who are bearish are regarded as someone spreading fear, uncertainty, and doubt (FUD), even if their criticism is legitimate. This is because people do not want objective analysis that contradicts their confirmation bias. They simply want information that confirms their confirmation bias to enhance their Hopium.
2. Sunk Cost Fallacy
Have you ever sat through an awful movie in the theatre with the rationale being that since money has been spent here, might as well get the most out of it? Unfortunately, we do not realise that by watching the movie we are not going to get our money back. While this appears to be logical, you are succumbing to the sunk cost fallacy.
The sunk cost fallacy takes place when we are unable to cut our losses because we have already invested money or time in an activity. Instead of making the reasonable decision to maximise our utility at the time, we end up trying to make up for lost time or money by spending more time or money.
Assume that instead of a movie, you invested in a volatile cryptocurrency asset. This asset’s price has dropped by more than 90% in the last month. When we consider selling, we feel an overwhelming sense of regret and instead spend more money on the asset, hoping to recoup our initial investment and break even. This is because people are risk-seeking when faced with prospective losses (a phenomenon known as loss aversion), yet risk-averse when faced with the chance of potential rewards.
3. Anchoring Bias
When trying to make a decision, people frequently use an anchor or focal point as a reference or starting point. Similarly, historical information strongly influences our assessment of a financial asset. The anchoring bias states that the initial information you receive is weighted more significantly in any subsequent evaluations. It makes no difference how factual the information is; it may still permeate into your reasoning.
I for one have fallen victim to this common cognitive bias not so long ago. My evaluation of the crypto project, Fantom (FTM) was severely overvalued at the time of investing. My introduction to the project was predicated on the possibility of the price of FTM rising to $30 in a year from $2 at the time of writing, a whopping 1400% increase. Currently, 1 FTM trades for 0.21 dollars. I subconsciously chose to base my investment thesis on the anchor of price reaching a target of 30 dollars even if there were undeniable signs of a decline in the market.
4. Motivating Uncertainty Effect
Motivating-Uncertainty Effect is a psychological phenomenon in which people are driven more by uncertain rewards than by fixed rewards. We are often more motivated by incentives of unknown magnitudes than by known benefits because the uncertainty makes it feel like a game.
We are drawn to risky investments because of the motivational uncertainty effect. Even though the odds of landing on the next 1000x dog-themed meme coin are stacked against us in a market with over 21,000 different cryptocurrencies, we choose the odds over consistent moderate growth from proven assets like Bitcoin or Ethereum. In the case of the motivating uncertainty effect, it is not the reward that motivates us. It’s the uncertainty of the game that surrounds it.
5. Affect Heuristic
The affect heuristic is a mental shortcut in which people make decisions influenced strongly by their present emotions. Essentially, your affect (a psychological term for emotional response) influences your choices and decisions. It is a bias in which emotions such as fear, anxiety, surprise, and pleasure influence and speed up decision-making. It is almost involuntary, unplanned, and in response to some form of stimuli. As a result, the estimation of risks and benefits is focused on emotion rather than facts.
6. FOMO or the Fear Of Missing Out
FOMO, a common phenomenon in the crypto sphere and one that I’ve been guilty of participating in. In this market and the age of social media, the sense of missing out can be very overwhelming for us FOMO-sapiens. You missed out on a large win, but because it’s still increasing, you think it’d be illogical not to participate. People are ecstatic, and it appears that a rocket is on its way to the moon, but you must act quickly to secure a ticket. Unfortunately, by the time FOMO kicks in, the rocket has most likely already left the station, forcing you to make a bad investment at an inopportune time.
Individuals have unique emotional responses to different events in their lives and the excitement, disappointment or fear that comes along with investing are no different. Recognizing that you will not always be correct and identifying your errors is a good place to start.
- Design and follow a strategy: Firstly, it’s perhaps useful to underpin your goals, whether that be time in the market or an exit plan when a percentage return on an investment is realised. Following a long-term approach reduces the possibility of falling into short-term pitfalls. A systematic investment plan (SIP) or cost averaging is another underrated strategy. This is a technique in which a preset amount of money is allocated in regular periods (daily, weekly, biweekly, or monthly) to purchase an asset regardless of price movement. Spreading out purchases evenly rather than making a large purchase will lessen the risk of big financial loss, which is beneficial not just to your wallet but also to your peace of mind. This allows you to buy assets at lower prices and average the purchase price, reducing risk. This effectively removes the burden of predicting market bottoms and tops. In the absence of a crystal ball, the SIP strategy may be the safest bet. While this may appear robotic and boring, Morgan Housel’s comment serves as a good reminder:
“It helps, I’ve found, when making money decisions to constantly remind yourself that the purpose of investing is to maximise returns, not minimise boredom. Boring is perfectly fine. Boring is good” — Morgan Housel, The Psychology of Money.
2. Combat your confirmation bias: The herd mentality and strong community nature of cryptocurrency make it easy to succumb to confirmation bias. As a result, before making financial decisions involving cryptocurrency, individual investors like us must always seek numerous sources of accurate information. Search for both a bullish and bearish perspective to help you overcome your confirmation bias.
3. Don’t follow the crowd: The allure of social power is difficult to ignore. However, if one wishes to be successful, one must resist the impulse to follow the crowd and forge their own path. “Be fearful when others are greedy, and greedy only when others are fearful,” Warren Buffet says eloquently. People who can accomplish this have a greater likelihood of making money in a market fuelled by mass emotion. The Fear and Greed index is an excellent instrument for assessing market sentiment.
4. Patience: As the saying goes “investing is a marathon, not a sprint.” This also applies to the volatile crypto markets, even if it is assumed that this is a space for quick money. Coming in with a get-rich-quick mentality, just like in traditional markets, is likely to lose you money. We may not be on the moon tomorrow, but the next bull run will come around; it is up to us, like marathon runners, to manage our emotions until then.
New to trading? Try crypto trading bots or copy trading