The entry into the cryptocurrency market often starts with a promising pitch – maybe from a friend or colleague who claims that it is easy money: “Put your money somewhere and watch it double or triple!” When lay people hear about the growth potential of cryptocurrencies, many of them take the plunge in to crypto trading without fully appreciating and understanding the risks inherent to all types of trading.
While risk of market volatility is well known, it is the psychological biases that often blindside new traders. Contrary to popular belief, we humans aren’t always rational. As psychologist and Nobel Prize winner Daniel Kahneman once puts it, our decisions are based on irrationality, heuristics and emotions. Our decision making framework works well for us in daily life, but makes us vulnerable to poor trading or investing decisions.
Therefore before you start trading cryptocurrencies or crypto derivatives, it is good to be aware of the following perceptual mistakes:
You may have noticed that more and more people are dealing with crypto currencies and are actually investing in the market. Maybe you are careful enough to inform yourself before you invest. But if so many people are willing to put their money into crypto, it must be worth a try. Isn’t it?!
When we humans are unsure what choices we should make, we look at how others behave. Using the majority to make one’s own decisions is a heuristic method called “social proof. This is exploited by traders through so-called “shilling”. People “shill” a particular cryptocurrency to make it look like many people are buying that currency, and thus boost the demand for the cryptocurrency.
Since crypto currency technology is very complicated and many people do not fully understand it, many are guided by others. When making an investment in cryptos, being aware that you are prone to herd mentality will help you avoid some costly mistakes.
We all have to start somewhere. To deal with your limited knowledge of crypto currencies, new traders tend to look up to someone who has already made a lot of money with Bitcoin and Ether. This person’s track record of success in trading motivates newbies to emulate and follow him.
So we tend to follow someone who has reached a certain status in an area because we learn from an early age to take authority figures seriously. But authority figures aren’t always right either – especially in a market where new, hard to understand technologies emerge every day.
Imagine hearing someone talk about how they once bought a cryptocurrency for little money. But it’s too late for you now, isn’t it?
The inertia that comes over you now is the Inaction Inertia. It is the feeling that people experience after missing a deal. Inaction inertia makes it less likely that people will buy the same product in the future for an increased price. People hate to miss something, especially when it comes to investment opportunities.
In cryptocurrency trading, this conservative emotion can sometimes save you from losses. But it can also reduce your profits considerably. The first time you hear about a new coin, its price may have increased by 90 percent. Sluggish as you are, you now believe that it is far too late for you to get in. You tend to discount that there could still be material upside and the value of the crypto currency could rise by a full 290 percent tomorrow.
FOMO effect – the fear of missing out on something is perhaps the most common and obvious psychological phenomenon that encourages people to invest. Crypto traders have a tendency to brag about their successful trades or investments. This results in hype which sucks in many a novice trader or lay people.
The feeling of missing something can be very strong for us “Fomo Sapiens”. Consider a situation where you have missed a big investing opportunity. Your friends/ colleagues have made handsome profits already. The price of the asset continues to rise and with it the discussions about this opportunity in news and social networks. This is the perfect backdrop for FOMO to set in. In times like this, it is important to keep a cool head and evaluate the opportunity rationally. Giving in to the FOMO usually doesn’t work out.
“Confirmation bias” is the term given to the human tendency to prefer information that strengthens our hopes or convictions, while ignoring information that runs contrary to our beliefs.
Consider a situation where you have invested a significant sum in a blockchain project through an IEO. Now there are several rumours about this project, both positive and negative. Confirmation bias makes you more likely to focus on the positive remarks to validate that you made the right investment decision. You’d tend to pay less attention to the negative remarks.
Let’s see how various biases can come together and nudge you towards a wrong investment decision. You’d reason that the project has to be good, otherwise you wouldn’t have invested in it. You’d look at other people who have invested in the same project (social proof). Furthermore, if a well-known investor/ crypto influencer has backed the project, you are likely to use it as a reason to stay invested (authority).
In 1938, accountant Ralph Nelson Elliott hypothesized that collective psychology of investors results in predictable patterns in financial markets. These patterns, known as Elliot Waves, are driven by combined optimism and pessimism in the market. Ultimately, these waves are driven by mass psyche and lead to bull/ bear markets.
Cryptocurrency domain which is less mature than traditional financial markets have even more prominent and fast changing cycles. We refer to them as the Hype – FUD (fear uncertainty and doubt) Cycle. The sentiment about a cryptocurrency can swing from hype to FUD (and vice versa) very quickly. Having an understanding of these cycles and taking advantage of them instead of trying to play catch-up with the ever changing cycles can make you a better trader.
There are of course many other cognitive biases and psychological effects that can lead to material impact on your crypto trading. However, the ones we are listed are arguably the more important ones that you should know about. Being aware of these biases will not result in guaranteed trading success, but it will certainly make you a more intelligent and savvy crypto trader.
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