We, humans, are weak in financial-decision making, learn how to detect errors in your thinking.
Human beings are great decision-makers when it comes to building, conceptualization, coming out with feasible solutions to real world problems our survival and evolution for thousands of years despite diseases, hostile predators and rough environments do prove that we often take good decisions collectively. Sadly, financial decision-making is one domain where humans fails miserably in the process of deciding, this encapsulates trading in various time-horizons, long-term investing and gambling.
Heuristics are the ‘shortcuts’ that we all use to reduce task complexity in judgment and choice, and biases are the gaps, the incoherent valley between logical behavior and the heuristically determined behavior.”
Learning and understanding these biases will help you identifying them before they contaminate your thought-process, developing this kind of self-awareness when it comes to money and all the decisions related to finance will optimize each step that make up your financial journey, hopefully to immense wealth.
You must read this article if:
- you tend to buy tops and sell bottoms because you FOMO
- you held onto -99,9% loss because you didn’t want to accept a -15% loss
- you forgot to take profit because you listened to youtubers convincing you will become a Billionaire by holding only to end up at your boring job or McDonald’s.
Not being aware of crucial cognitive biases is the root-cause of the afore-mentioned errors. Learn and be aware of those in order to adopt a flexible and adaptive approach.
1/ Recency bias is a cognitive bias wherein you tend to give more importance to recent events or information on twitter while making decisions to buy or sell. This bias can influence how people perceive and react to information, often causing them to prioritize the most recent data over older or fundamental facts or historical information.
In the context of crypto markets, recency bias might lead individuals to place more significance on recent price movements or trends when making investment decisions. For example, TRB has pumped 300% in the month of December 2023, an untrained or beginner trader/investor influenced by recency bias would have been more inclined to believe that the trend will continue, potentially overlooking the fact that the TRB team moved large sums which led to the price rally. TRB ended the year by dumping more than 80%: avoid letting recent events dominate your decisions. Similarly, drops in crypto staple such as BTC, XMR or ETH do not mean that their price will continue falling, and a sudden rise doesn’t guarantee sustained gains.
2/ Anchoring bias a cognitive bias where individuals rely too heavily on the first piece of information provided (the “anchor”) when making subsequent decisions.
This piece of information, this anchor comes in different forms:
- Price Anchoring: you may place your expectations based on a specific historical price level. For example, if a crypto previously stagnated around a price mark of $100, you might base your perception of the crypto’s value around that price, thus leading to biased decision-making.
- Forecast Anchoring: like the overused “Bitcoin to 1 million” prediction Once a forecast is set or has been repeated over and over, individuals may anchor their expectations around that forecast, even in the face of new information that invalidates that thesis.
- Time Anchoring: Anchoring bias can also be related to time frames. Today, everyone is expecting a price rally in crypto-prices following the BTC halvening in April 2024. However, a price rally has to be sustained by macro forces within and outside of crypto-markets. All market participants might be anchoring their expectations around the idea that markets will automatically rally after April 2024, even if conditions have changed: there is less and less liquidity in the whole financial system, the crypto regulations are lining up and the number of inter-states conflicts is the highest in decades…
Anchoring bias can impact financial decision-making by preventing you from adequately adjusting their views in response to new and relevant information. It can lead to stubbornness, a reluctance to change investment strategies, unrealistic price expectations, or influence perceptions of value.
To mitigate this kind of error, especially as a novice, you should be aware of your initial anchor points and actively seek to reassess their views based on the most current and relevant information.
3/ The bandwagon effect is omnipresent in crypto markets it induces most participants to conform to prevailing trends, NFT, ordinals, memecoins, potentially giving rise to asset bubbles followed by abrupt market downturns, contingent upon whether the prevailing sentiment leans towards buying or selling. The DogeCoin and BoredApe NFT frenzy are perfect examples, Elon Musk and other celebrities drove the bandwagon to implosion, embarking individuals driven by the fear of missing out (FOMO), totally omitting individual assessments and due diligence.
In such instances, decisions are made based on the perceived momentum of the crowd and collective enthusiasm rather than a thorough evaluation of the investment’s merits. Buying or selling merely due to the prevalent market sentiment can yield unfavorable outcomes.
4/ Gambler’s Fallacy, a bias commonly seen in crypto as everyone is a genius in a bull market. This cognitive bias occurs when people believe that past events or outcomes in trading influence future outcomes. For example, a trader who profited during a bull run by buying 4 memecoins and subsequently believing that his reading of market is infallible, that he’s an outstanding trader. This is a fallacy, as each trade is an independent event and the outcome of any one trade does not affect the probability of future outcomes. The negative consequences rooted in this fallacy are revenge-trading in case of large losses, over-trading and plain poor decisions due to overconfidence.
The best way to address this fallacy is by first being aware of the Gambler’s Fallacy, relying solely on data and strong analysis by respected figures when making your investments decisions while using strict risk management techniques (stop losses, position sizing) to protect your profits and limit losses.
5/ Sunk Cost Fallacy is a cognitive bias where you continue investing or holding a project even when it is clear that the investment is unlikely to yield positive returns or deliver any working products/solutions. In other words, individuals thinks about all the capital he has put in so far (sunk costs) when making decisions about the future, despite the project showing all signs of a doomed venture. Cardano is a striking example as they keep making announcements about future meetings while they have still not delivered a single working product since inception.
In the context of investments, the sunk cost fallacy can lead you to make irrational decisions by considering the money, time already invested, rather than objectively evaluating the current and future potential of the investment. It’s important to note that rational decision-making should focus on future costs and benefits rather than past investments that are long gone. REEEEKKKKKKKKKKKKKT => Adapt Quickly or Die.
6/ Overoptimism Bias (Exaggeratedly optimistic expectations) Exhibiting excessive confidence and arrogance, people who claim they will be able to squeeze 2% of profits per day after watching youtube tutorials… This naive stance frequently leads to ventures with heightened risks. It is imperative not to dismiss potential risks under the assumption that one’s investments will invariably flourish whether by actively trading or buying and holding.
To avert such outcomes: establish and rigorously stick to professional level risk management protocols combined with due diligence to understand where you allocate your capital.
7/ Status-quo bias is best represented by those who bought XRP at 1$ in 2017-2018, this bias refers to the tendency to prefer maintaining their existing investment positions or portfolios rather than making changes, even when it might be financially beneficial to do so. This bias which rhymes with comfort is rooted in a psychological inclination to stick with the familiar or current situation rather than embracing change, even if the status quo is condemned to lose.
Speak to anyone holding into failed projects such as XRP and Cardano and you will hear and sense:
- Reluctance to Sell: hesitant to sell existing holdings, even if market conditions or fundamental analyses suggest that selling would be a prudent move.
- Inertia in Decision-Making: reluctance to make changes to their investment strategy, even when presented with new information or changing market dynamics.
- Comfort with Familiarity: The bias often arises from a comfort with the current portfolio or investment positions. As an investor, early or late, you may be more willing to tolerate existing shortcomings than face the uncertainty of change.
- Endowment Effect: Status-quo bias can overlap with the endowment effect.
To mitigate the impact of status-quo bias, you should regularly reassess your portfolios and be honest with yourself when integrating new information about market developments, and be open to adjusting their strategies based on new information. Be proactive or prepare to hold losing projects for a long time while new narratives are printing 4 digits returns !