When it comes to investing in crypto, it’s important to be aware of all the factors that can affect your decisions – and that doesn’t just mean watching market trends and doing your maths. Traditional finance theory assumes that people are rational and that the markets are efficient – but we know this isn’t true. The stock market is often erratic and prone to swings that can’t be accounted for by the facts.
When it comes to investing in crypto, it’s important to be aware of all the factors that can affect your decisions – and that doesn’t just mean watching market trends and doing your maths. Traditional finance theory assumes that people are rational and that the markets are efficient – but we know this isn’t true. The stock market is often erratic and prone to swings that can’t be accounted for by the facts. Why is this? To answer that question, we need to delve into behavioural finance. This growing field of knowledge has shown that market events can be better explained by looking at human psychology in more depth, and understanding the central roles our thoughts, beliefs and emotions play in our decision-making, rather than assuming we’re all just rational robots making fact-based decisions.
To be successful in today’s volatile investment climate, it’s crucial to develop strategies that take into account the irrational and emotional nature of the markets, rather than relying on outdated assumptions about rational decision-making. Behavioural finance has introduced many crucial insights into the markets, and one of the most useful is the idea of cognitive biases.
What are cognitive biases?
Cognitive biases can be defined as the effects of our belief systems on our decisions. We don’t make decisions in a vacuum. Instead, our pre-existing beliefs shape our behaviour and often hamper our judgement. That’s because the brain has evolved to rely on heuristics (mental shortcuts), rules of thumb, and cognitive filters to make decisions. This efficient way of working is ideal in many contexts – after all, cognitive biases such as avoiding the unfamiliar or following the herd are what kept our primitive ancestors safe. The caveman who stopped to carefully analyse exactly which big hairy creature was chasing him was likely to end up as lunch, while those who just ran would live to see another day.
However, when it comes to investing, our efficient human brains can be our own worst enemies. Now these cognitive biases work against us, making it too easy to follow the crowd, rely too much on mental shortcuts and make bad decisions.
To help prevent these common thinking errors and ‘debug’ the brain, we need to get smart about cognitive biases.
How can learning about cognitive biases make you a better investor?
Learning about cognitive biases help you recognize and overcome the systematic flaws in reasoning that can lead to making wrong decisions while investing. By understanding the role that cognitive biases can play in investing, you can become a more logical and objective decision-maker. Understanding your personal biases is crucial to ensuring you do not get in the way of your own success as an investor and can help you maximise your chances of making the best choices possible. By using research from psychology and behavioural economics, you can develop the tools and strategies to become a better trader and improve your performance in the markets.
With this in mind, let’s go over the most prevalent cognitive biases crypto investors are susceptible to, so you can make more informed decisions and avoid falling into these common traps.
- Confirmation Bias: ‘I knew I was right!’
Confirmation Bias refers to the tendency for people to seek out, interpret, and remember information in a way that confirms their pre-existing beliefs and attitudes, while ignoring or discounting information that contradicts them. In other words, people tend to look for evidence that supports what they already believe, and they often ignore or dismiss information that contradicts their beliefs. This bias can be particularly problematic in decision-making, as it can lead people to make choices that are not based on objective or rational criteria, but rather on their own biases and prejudices. In the context of crypto investing, confirmation bias can lead investors to only seek out information that supports their investment decisions and ignore information that suggests they should sell their holdings. For example, an investor who believes that a particular cryptocurrency will continue to rise in value may only read articles and listen to podcasts that support this belief, and ignore any negative news about that investment.
Confirmation bias can create an incredibly powerful self-reinforcing cycle, where people’s beliefs become even more entrenched and resistant to change over time. This is how conspiracy theories take root – individuals actively seek out information that confirms their beliefs and ignore or dismiss information that contradicts them. This selective attention to information can make it seem as though the evidence for the conspiracy theory is stronger than it actually is, leading people to become more convinced that the theory is true. This is particularly true when the narrative around the theory is complex and intricate enough to evade any attempts to definitively prove it wrong. This only goes to show how confirmation bias can lead people to cling to faulty beliefs – even in the face of overwhelming contradictory evidence or logical inconsistencies. Left unchecked, confirmation bias is a dangerous force.
All this goes to show how important it is to approach information with an open mind, actively seek out a wide range perspectives and sources of information, and be willing to reconsider your beliefs in light of new evidence or information.
2. Herd mentality: ‘Everyone else is doing it”
FOMO, or ‘fear of missing out’ isn’t just millennial internet speak – it’s also an expression of herd mentality, another powerful cognitive bias that can impact our financial choices. Herd mentality, also known as herd behaviour or the bandwagon effect, refers to the tendency for individuals to conform to the behaviour or opinions of a group, rather than making decisions based on their own independent thinking or analysis. This phenomenon can be seen in a wide range of contexts, from workplaces and social media to politics and consumer behaviour.
Herd mentality can be driven by a variety of factors, including social pressure and a desire to conform to the norms and values of a particular group or community. When we are uncertain or feel vulnerable, we tend to look to the behaviour of others as a way to reduce our own perceived risk or increase our sense of belonging.
In social media, herd mentality can lead to the spread of misinformation and the amplification of extreme viewpoints, as people share and amplify content that aligns with their own biases and beliefs. All this can cause investors to follow and copy what other investors are doing, influenced by emotions and instinct rather than their own independent analysis, and this is a recipe for unwise investments. In the financial markets, herd mentality can even lead to market bubbles and crashes, as investors follow the crowd rather than conducting their own independent analysis of market conditions.
To avoid getting sucked into herd mentality, try to approach decision-making with a critical and independent mindset, and to educate yourself by reading widely and researching deeply. As Warren Buffet eloquently points out, “Be fearful when others are greedy and be greedy only when others are fearful.” Staying aware of this bias can help you make better choices about whether (or not) to follow the crowd.
3. Authority bias: ‘If he says it’s true, then it must be’
Authority bias is a cognitive bias that involves giving undue weight to the opinions or actions of those in positions of authority, without critically evaluating their expertise or competence. This bias can be seen in a wide range of contexts, from personal relationships to professional settings.
In the world of crypto, a common example of authority bias is the tendency to trust social media influencers simply because of their title or position, rather than evaluating their skills or qualifications. This can lead individuals to follow advice that may not be in their best interests, or to overlook warning signs or red flags that would otherwise be cause for concern. After all, experts can be wrong – or they can have darker motives, as we can see from the numerous crypto scams that were enthusiastically shilled by ‘experts’ only for the rug to be pulled from under the investors’ feet.
To avoid authority bias, make sure you critically evaluate the credentials and expertise of those in positions of authority, instead of blindly following their advice. Seeking out diverse perspectives and sources of information through taking every chance to educate yourself is the only way to improve your strategy and your returns.
4. Overconfidence bias: ‘Guess I’m a natural’
One of the most persistent cognitive biases, overconfidence bias involves overestimating your own abilities, skills, knowledge, or performance in a particular task or situation. Individuals who exhibit overconfidence bias tend to be highly optimistic and have an inflated sense of their own abilities – personality traits that can often be found in successful investors too. But overconfidence bias may lead individuals to underestimate the difficulty of a task, their own lack of ability, or the likelihood of failure, causing them to take unnecessary risks or make poor decisions.
Overconfidence bias can also lead individuals to discount or ignore any information that might call their expertise into question, as they may believe that they are already doing well or that they know better than others. Riding high after some chance success, it’s easy for an investor to think they have all the answers. But this can create blind spots which, at best, prevent investors from learning from their mistakes or improving their performance, and at worst, lead to financial ruin.
To tackle overconfidence bias, approach decision-making with a realistic and objective mindset. This involves acknowledging your own limitations and seeking out and considering different ideas and perspectives. Keeping an open mind for life is the best way to learn and grow.
5. Action bias: ‘Don’t just sit there, do something!’
Just like the cavemen we mentioned earlier, modern humans don’t like to sit around and let things happen: we have a strong preference for doing something rather than nothing, even when taking action may not be the most effective or appropriate course of action. This is known as action bias. This bias is often seen in high-pressure or uncertain situations, where individuals feel a sense of urgency or a need to do something, even if that something may be ineffective or counterproductive.
In investment and financial decision-making, action bias can lead to impulsive or ill-advised trades or investment decisions, rather than waiting for more favourable market conditions or taking a more measured and strategic approach. Action bias can also lead to a bias towards immediate rewards, rather than considering the long-term consequences of your actions. Couple this with the impact of herd mentality, the power of ‘hype’ around particular investment opportunities, and the influence of figures of authority, and investors can fall prey to a false sense of urgency. This can create a short-term mindset that is focused on immediate results, rather than taking a more strategic and forward-looking approach.
To avoid the impact of action bias, take a step back and carefully consider the situation before you act. This involves assessing the risks and benefits of different courses of action, and taking a more measured and thoughtful approach to decision-making. It may be helpful to seek out advice or feedback from others, as well as considering alternative perspectives and viewpoints. This can help you make better decisions – even if that decision is to do nothing.
6. Hindsight bias: ‘I could have told you that!’
Hindsight, as they say, is always 20/20 – and that’s the definition of hindsight bias, the tendency to believe, after an event has occurred, that you would have predicted or expected the outcome. For example, looking back at past market crashes, an investor suffering from hindsight bias will confidently claim that they would have seen the writing on the wall, despite the fact that so many intelligent people did not.
In our own lives, hindsight bias can lead us to the conclusion that past positive outcomes were a result of our ability to understand and predict what the market will do. Hindsight bias also informs the belief that negative outcomes are the result of events that cannot be predicted.
All this can engender overconfidence in your own abilities and decision-making, and can create a sense of false certainty about the future. It can also lead individuals to overlook or discount important information that was not available or considered at the time of the event, and can create a sense of inevitability about the outcome.
Ultimately, we have to recognize that events are often unpredictable and that outcomes are not always certain. It’s also important to take a more critical and reflective approach to decision-making, and to consider the factors and information that were available at the time of the decision, rather than looking back with the benefit of hindsight.
7. Loss aversion bias: ‘I don’t like losing’
Loss aversion bias is a cognitive bias that describes the tendency for people to feel the pain of loss more strongly than the pleasure of gain – as any Las Vegas gambler can tell you. Individuals tend to be more risk-averse when faced with the possibility of losing something than they are willing to take risks to gain something.
Loss aversion bias is a key factor in decision-making related to investment and financial planning. It can lead individuals to hold on to underperforming investments for too long, in the hope that they will eventually rebound and avoid selling at a loss. This can result in missed opportunities for better returns, as well as increased exposure to risk.
Additionally, loss aversion bias can cause individuals to make decisions based on fear rather than logic, leading to irrational behaviour in times of market volatility or uncertainty. For example, investors may panic and sell their holdings during a market downturn, rather than holding on and waiting for the market to recover.
When it comes to avoiding loss aversion bias, start with taking a clear-eyed look at your strategy, making sure your actions reflect the facts, not your feelings. This may involve diversifying investments, setting clear goals and risk tolerance levels, and regularly reviewing and adjusting investment strategies as needed. It’s also important to recognize that some level of risk is inherent in investing, and that losses will always occur from time to time.
How can you overcome cognitive biases?
These are only just a handful of hundreds of cognitive biases can have a significant impact on an investor’s decision-making when investing in cryptocurrency. However, there are strategies and techniques that can help us overcome these biases and make more informed investment decisions.
Firstly, developing awareness, or metacognition, is an essential step in overcoming cognitive biases. Metacognition could be defined as ‘thinking about your thinking’, and it involves recognizing the presence of biases and actively questioning your own thought processes and assumptions. By becoming more self-aware, we can identify potential biases that may be influencing our decision-making and take steps to address them.
Alongside this, we need to develop a solid, objective plan for investing, risk management, and trading psychology. This plan should include clear strategies for minimizing risk, managing emotions, and making informed investment decisions. It’s important to stick to this plan and avoid making impulsive decisions based on emotions or short-term market fluctuations.
Using a cognitive bias checklist when making investment decisions can form an important part of this plan. This involves identifying potential biases and systematically evaluating them to ensure that they are not influencing your decision-making.
Planning is one half of investment success, but you also need to harness the power of hindsight to reflect on what worked and what didn’t. Keeping a trading log can also be a powerful tool in overcoming cognitive biases. This log can help you identify patterns and learn from your mistakes, allowing you to make better-informed decisions in the future.
It’s also possible to use cognitive biases to your advantage when investing in cryptocurrency. For example, by understanding the herd mentality bias, you can identify coins that have a good narrative, charismatic leaders, and strong marketing, which may have a higher profit potential.
Finally, balancing discipline and flexibility is key. Yes, you should remain disciplined in following your investment plan, but also you need to be flexible and adaptable when market conditions change. By striking this balance, you can make more informed and effective investment decisions, and minimize the impact of cognitive biases on your portfolio.
Cognitive biases: the key to unlocking the psychology of the market
Understanding cognitive biases is crucial for successful crypto investing. The crypto market is highly volatile and risky, and new developments unfold every day. In this fast-paced environment emotions and biases can cloud our judgment and lead to poor investment decisions. By recognizing and addressing our cognitive biases and those of others, we can make more rational and informed decisions based on data and analysis. It is important to approach crypto investing with a clear and objective mindset, rather than letting emotions and biases drive our investment decisions.
With a deeper understanding of our cognitive biases, we can navigate the crypto market with greater confidence and achieve our financial goals.
