Mental errors and heuristics in trading cryptocurrency.

A guide to help you decide between 10.000 cryptocurrencies: The most important asset is your financial education!

Being aware of these bias and heuristics is usually the best way to avoid them. These tips will help you to draw the right conclusions before making any investment decision. Think long-term and try to really understand the technology. Unfortunately, the investment decision is less rational than you think. It consists of several irrational elements.

Why we’re such bad losers: The loss aversion

An answer to the question, on why so few people take risks despite many good opportunities, could likely be found in the research of Kahnemann and Tversky. Their Prospect Theory (Kahnemann & Tversky, Prospect Theory: An Analysis of decision under risk, 1979) describes two important points:

  1. On the one hand, the probability of an option influences the decision.
  2. On the other hand, losses are perceived as being worse than equivalent gains.

Bitcoin is a highly “risky” asset class compared to bank savings accounts. Prices fluctuate daily (volatility) and the value of the assets can therefore fluctuate by several percentage points within a few hours.

In a savings account however, there is always a value left over. The negative potential of the downward trend of bitcoin weighs more heavily in the minds of investors than the possible positive and unlimited upwards returns. Moreover, people generally shy away from risks, even if the opportunities are much higher.

Figure 1 (Image by author): The Prospect Theory.

The timing of buying and selling also depends on this theory. Since we experience losses more painfully than equivalent gains, it often happens that gains are taken too early and losses are realized too late. As long as bitcoin is not sold, the loss is mentally only a possible loss. Bitcoin could recover again (what it always did in the past).

For example, if you bought at the peak of the bubble in 2017, you had to wait exactly 4 years to be back in profit.

Figure 2: https://coinmarketcap.com/currencies/bitcoin/

The Availability and Recognition Heuristic

Humans like to use mental shortcuts (heuristics) to save time and energy. One of them is the availability heuristic. Here, an information which is particularly quick and easy for us to retrieve, is given a higher significance (Felser, 2015).

According to this, particularly a simple information such as the reputation (the brand) or the name of the asset, should have an influence on the decision of investors. Apparently, many private investors invest according to the motto: “If I know it, I’ll invest in it”, as the availability heuristic would prove.

Recognition heuristics come to a similar conclusion — the availability of information influences judgement (availability heuristics), and also affects whether the options can be remembered at all. The effect of the reminder has a positive effect on the evaluation of the option (Felser, 2015).

Don’t let the most obvious details influence you. Bitcoin is bad for the environment, it’s too slow or too expensive (Bitcoin Lightning fixes this)? This might be the first information that comes to your mind as a beginner because of the media. But this is exactly where the mistake lies. Expand your view and remain open and critical to the mainstream opinion.

The regression to the middle

For those who believe in the efficiency of the markets, the current price also reflects the fair value of the asset. But the real fair value does not necessarily have to be the current price. The bitcoin price constantly fluctuates around the true value. Smart people invest counter-cyclically. Everyone has a different fair value over an asset. You have to try to make your own calculation. Many compare bitcoin to gold, for example. If bitcoin has better properties than gold, it seems obvious that bitcoin would have a similar or even higher market capitalization. Then bitcoin would be valued at about $500,000. Make your own calculation.

Figure 3 (Image by author): The Idea of value Investing.

Now the psychological principle of “regression to the middle” comes into play. This means that, among other things, numbers will gravitate towards their average. It can happen that there are outliers (high volatility). Over a long period of time however, these numbers tend to come closer to their mean or average (fair value). These outliers are the exaggerations (bubble) or understatements (fear) that can occur. The average is the true fair value of the asset from which the outliers move away in the short term.

The stock-to-flow model tries to calculate the fair value of bitcoin. As you can see the price always moves around the “fair value”.

Tip: Make sure you pay attention to the time of purchase. By this, I do not mean that you should time the market and try to predict economic cycles. I mean that the entry price is extremely important for future returns. Also, pay attention to the trend of the asset. This does not mean to do chart analysis, but rather, the recognition of opportunities. In the worst case, experience shows that you have to wait 4 years for bitcoin to reach a new all-time high (see Figure 2). How about a regular purchase via DCA (dollar cost average)?

Investing with focus: The influence of irrelevant information

The financial news are full of (miss)information. The daily news situation concerning politics and economy is constantly changing. China is banning Bitcoin every week, but does this information really help us?

Too much news is more likely to do harm than good, precisely because we feel the need to use it (Felser, 2015).

Tip: As an investor, you should concentrate on the fundamentals of investing and focus on impact of bitcoin. Don’t let your investment decision become too complex. Above all, you yourself must understand what you invest in. Do not listen to other investors. Find the key figures and information that are important for you. Less is sometimes really more. There are many good books to understand Bitcoin and the technology behind it. Read them!

Correlations — Can prices be predicted?

The financial press is full of promising correlations between various key figures and other characteristics. For example, the month or even the time of day supposedly has an influence on the price. The chart is not a scientific tool with which you can analyze a price.

“One problem with correlation is that people (especially those who are not very familiar with statistics) often cannot resist the temptation to interpret a correlative relationship causally. This means that a “cause-and-effect” direction between variables is assumed. A direction of effect, if any, is often not captured by this.” (Lammers, 2003, p. 83).

Just because the historical chart is related to the current price, it does not necessarily say anything about its causality/future. Always remember that traders look at the past and only make a “prediction” in retrospect. Do not be fooled by correlations that have nothing to do with each other or are influenced by other unknown factors.

Big numbers and The anchor effect

An irrelevant number can influence human decision making (Felser, 2015). The price of a single bitcoin is completely irrelevant information. The question is; what is the fair value and what is the impact of the technology. Has something fundamental developed (nation states buying and mining Bitcoin)? How is the industry and the competition developing (Twitter using Bitcoins Lightning)? These are elementary questions that should justify an investment and not the price of a bitcoin.

You can divide a Bitcoin into smaller units as many times as you want. Just because something seems expensive doesn’t mean it’s worse. Cryptos that cost less than $1 don’t automatically have a chance to perform better.

Was bitcoin expensive at $10, $100, $1000 or $10000? All of these numbers used to be all-time highs. The original entry price can serve as an anchor. Unfortunately, many investors check their portfolio value daily or almost hourly (Spier, 2019). These permanently volatile prices can influence and our decisions. It is better to choose a solid asset (that you understand and truly believe in) and wait and see what time brings.

“Patience is the most important thing in business and lack of it the most common mistake.” (Kostolany, 2008, p. 127)

Tip: The changes in the short-term price are usually completely random. Don’t drive yourself crazy over it.

Group norms & social reliability

Stick to your area of expertise and only invest in something you understand (Schröder, 2008). Find your own style. Just because a technology is “in” or in trend doesn’t mean that it is promising. A strong upward trend is usually followed by a counter-movement. High expectations or anticipations of success by new technologies (other cryptocurrencies) may not be met (Linden & Fenn, 2003).

Figure 4: Trend in new technologies. (Source: Linden & Fenn, 2003, p. 5)

“It is extremely difficult, especially for a relatively inexperienced speculator, to trade and buy against the general consensus, where colleagues, friends, the mass media and experts advise to sell. It’s because even those who know this theory and want to follow it change their mind at the last moment under the pressure of mass psychosis.” (Kostolany, 2008, p. 165)

“The greater the number of people who find any idea to be correct, the more a given individual will perceive the idea to be correct” (Cialdini, 1993, p. 105).

Mass psychology, among other things, controls the own behavior, so that we orient our behavior, thinking and decisions according to the other person (Pelzmann, 2010).

Above all, do not think you are smarter than other investors. Being down-to-earth is an important quality.

The psychological consistency

People change their minds only reluctantly. Admitting our own mistakes is not exactly one of mankind’s strengths. We prefer to remain consistent with the decisions we made in the past (Felser, 2015). You read a bad article about Bitcoin in the past? Maybe you should double check that the facts are up to date.

Tip: Learn from mistakes. Do not stop, but try to learn more. We love simplicity and the status-quo, so changing our opinion is not one of our strengths. Fight against the theory of consistency and question yourself.

The sunken cost fallacy

“Low costs are taken into account, i.e. one looks to the past rather than to the future. Sometime it is economically irrelevant to the consequences of the current decision. You can imagine that such behavior is quite common. Consistency theories can explain this behavior: Every expenditure made in the past increases the commitment. In the end, the commitment may escalate: The more you have already invested, the more you persist in a meaningless asset.” (Felser, 2015, p. 233)

This heuristic is very important for altcoins. Promises are made there that are usually not kept. Once invested, however, the willingness to invest more and more unfortunately increases. “Never throw good money after bad”.

Tip: Always ask yourself with every new purchase, Which asset or investment is the best place for my money? Has the altcoins business model changed? Is my original investment reason still valid? Do you really understand the technology or do you believe in the marketing?

Are there too many cryptocurrencies? The psychological freedom of choice

There are over 10000 cryptos out there. You will probably never be able to analyze all the projects. By now, you perhaps have acknowledged that the existence of this enormous number of selections can hinder us in our investment decisions. A purchase probability is increased if the options are manageable (Felser, 2015).

In addition, the large selection again leads to regret. With a large selection, you have to attribute your selection and investment decisions to yourself. With a small number of choices, one could attribute the poor return to the limited offer (Schwartz, 2006). This freedom of choice, makes you unhappy.

Tip: Try to limit your selection to certain criteria that fit your strategy. Bitcoin is for example the only meaningful Proof-of-work and fully decentralized Asset out there. Do you want to make a decision between 10000 altcoins or for the biggest and safest decentralized network in the world?

In this video you can see the the development of the market capitalization of cryptocurrencies in 7 years.

https://www.youtube.com/watch?v=XawwwcN36fY

Many coins from 2013 are now unknown. Only one asset is permanently in first place. Will Ethereum be displaced by Solana or Cardano? No one knows for sure. What is quite likely is that Bitcoin will play an important role in the future.

The most important investment decision you can make is the one for education. Do you really understand what you are investing in. Do you know the difference between proof-of-work and proof-of-stake. Do you know what decentralization means? Do you know the origin story? Has there been an ICO where a team raised money? Is there a CEO with a team and office (centralization)? Does the project have a marketing department that can run manipulative ads? Are there only empty promises?

Why Decentralized Finance is Just Marketing:

Altcoiners often argue that there is a need for other projects besides Bitcoin because Bitcoin is supposedly too slow and you can’t build an ecosystem around it. I have dedicated this blog article to this misinformation:

#Bitcoin for Governments: fixed supply, open, global, permissionless, banking the unbanked, no remittance fees, financial inclusivity, GDP Growth,…