“I NEED TO FIGURE OUT A WAY TO BUY $50,000 WORTH OF DOGECOIN BY THE END OF THE DAY.”

There’s an age-old saying on Wall Street that the market is driven by only two emotions: fear and greed.

While this notion is oversimplified, the essence of the statement may ring true and has translated over to cryptocurrency. Trading psychology, or the emotional element of an investor’s decision-making process, is driven by fear and greed.

Along with knowledge, experience, and skill, trading psychology can play a key role in trading successes or failures. In this article, we will dive deeper into Behavioral Finance and the biases that impact cryptocurrency investors (as they do to investors in the stock market as well).

via hsi.com

What is Behavioral Finance Theory?

Behavioral Finance (a subfield of behavioral economics) is the study of psychological influences on investors and financial markets.

Behavioral finance focuses on the explanation of why individual investors oftentimes appear to lack self-control, act against their own best interest, and make irrational financial decisions based on their own personal cognitive biases instead of the facts at hand.

A cognitive bias is a systematic pattern of deviation from the norm or rationality in judgment. Cognitive biases cause individuals to create their own “subjective reality” from their perception of certain factors.

This “subjective reality” – rather than objective factors – has the potential to dictate the individual’s behavior in the world, and in this case their financial decision making.

Crypto Investors Tend To Allow Biases to Affect Their Decision Making

Behavioral biases are broken into two categories: cognitive errors or emotional biases. It’s possible for a singular bias to have elements of both, however one type will be dominant over the other. Below we will explore the following biases that affect investment decision making:

1. Mental Accounting
2. Herd Behavior
3. Emotional Gap
4. Anchoring
5. Self-attribution
6. Familiarity
7. Confirmation
8. Loss Aversion
9. Gambler’s Fallacy
10. Crypto Unit

Mental Accounting

Mental accounting refers to the differing values an individual places on the same amount of money, based wholly on subjective criteria. An individual classifies funds differently, and therefore is more apt to make irrational decisions in their spending and investment behavior.

Richard Thaler’s 1999 paper titled “Mental Accounting Matters” defined mental accounting as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.”

In order to avoid the mental accounting bias, individuals should treat money as completely interchangeable no matter where they allocate it. This means that the value of the money budgeted for everyday living expenses, a discretionary spending account, savings, and investments (including crypto) should be perceived to be the same.

Herd Behavior

Herd behavior is a phenomenon based on the idea that people join groups and follow the actions of others under the assumption that other individuals have already done their research (which is often a mistaken assumption).
When it comes to crypto, herd behavior emerges when one group follows what they perceive other groups are doing, rather than relying on their own analysis.

Remember my friend with the pressing need to buy Doge? His response to my request for more details was:
“My son told me that every time Elon Musk tweets about Doge, it jumps by at least 20%. And he hasn’t posted about it in a month, so my son thinks it’s definitely coming any day now…”

Investors make inaccurate or ill-informed decisions all the time.

Herd behavior at scale has the potential to create asset bubbles or market crashes, when panic buying and panic selling become apparent.

Emotional Gap

The emotional gap bias refers to decision making based on extreme emotions like anxiety, anger, fear, or excitement. Emotions play a massive role in causing people to make irrational investment decisions.

This refers back to the concept that markets are driven by fear and greed. This relates to the inherent volatility of all markets (especially crypto as we’re still in the early stages relative to other markets).

It’s important for an individual to understand their risk tolerance, because with increased volatility an investor can quickly find themselves outside of their comfort zones due to losses or market instability. When this occurs, it’s more likely that the individual can become vulnerable to these extreme emotions, which often results in seriously costly mistakes.

Anchoring

Anchoring describes an irrational bias towards attaching spending level to an arbitrary benchmark figure. This arbitrary benchmark then impacts an individual’s decision making with respect to an investment (i.e. when to sell the investment).

A potential consequence of anchoring is that investors with this bias tend to hold investments that have lost value. This is due to the fact that they have anchored their fair value estimate to the original price, rather than to the fundamentals.

As a result, they assume greater risk by holding in hope that their investment will return to the original purchase price.

via Carl Richards (nytimes.com)

Self-Attribution

Self-attribution refers to a tendency to make choices based on an overconfidence in one’s own knowledge or skill. Self-attribution can stem from an intrinsic “knack” in a specific area.

Individuals with this bias tend to rank their knowledge as more extensive than others, even on topics where it objectively falls short. They also have a tendency to attribute their success to their own hard work, skills, intelligence, and creativity. These individuals largely don’t believe luck and other outside influences play a role in their success.

On the flip side, when they experience failure, luck and other outside influences are the causes, not their knowledge and skills. Self-attribution prevents investors from learning and improving their strategies and skills over time.

Familiarity

Familiarity bias in investing is seen when investors are more apt to invest in what they know or have heard of.

In crypto, this can result in an individual investing in more mainstream coins that are often in the news. As a result, their crypto portfolio is not diversified, which can be crucial to reducing overall risk.

Confirmation

Familiarity bias has the potential to contribute to confirmation bias, which is when people seek out and naturally favor information that confirms their previously existing beliefs.

These investors are likely to ignore facts or data that go against their beliefs, which can skew their decision making abilities.

Loss Aversion

Loss aversion is a phenomenon where an individual’s perception of a real or potential loss is emotionally or psychologically more severe than an equivalent gain.

For these individuals, the perceived pain of losing $100 is often far greater than the joy they receive in gaining the same $100.

Gambler’s Fallacy

The Gambler’s Fallacy occurs when an individual incorrectly believes that a certain truly random event is more or less likely to occur based on the outcome of a previous random event or series of events. This mindset is incorrect due to the fact that past events do not change the probability that certain events will occur in the future. Every event should be considered independent, and its results have no bearing on past or present outcomes.

The Gambler’s Fallacy is also known as the Monte Carlo fallacy, due to the most famous example of the gambler’s fallacy occurring at a roulette wheel at the Casino de Monte-Carlo in Monaco in 1913. The roulette ball had fallen on black several times in a row, which led people to believe that it would soon fall on red. The gamblers began to heavily bet red on each subsequent spin, and the ball did not fall on the red square until 26 spins later. By then, millions had been lost.

In crypto, an example of this bias would be an investor liquidating a position once it has risen in value after a long series of positive trading. This happens because of the belief that because of a string of successive gains, their investment is now much more likely to decline.

Crypto Unit

Crypto unit bias is a phenomenon which illustrates how individuals are more likely to invest in whole units of a cryptocurrency rather than fractional ones. This is due to a psychological preference of owning a “complete” asset.

Someone who is a novice in understanding crypto may disregard Bitcoin or Ethereum because of the assumption that they are unaffordable.

What they may not realize is that they can purchase these coins in fractional amounts. Instead, they may seek cheaper alternatives that they’re able to buy in bulk, which have the potential to be more volatile in certain situations.

Let Us Help You Overcome Biases in Your Crypto Journey

At Crossover Capital, our number one goal is to provide people with the support, knowledge, and access to make informed decisions about their financial futures. Building a foundation for success starts with steady support and a customized approach. Crossover Capital is here to provide the necessary tools required for growth and to be a champion for our clients’ success.

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This material is intended for informational purposes only. It should not be construed as legal or tax advice, and is not intended to replace the advice of a qualified attorney or tax advisor.