Financial side of NFTs and money making questions (Pt. 2)
In the midst of the current geopolitical turmoil the NFT and crypto markets have arguably taken the greatest among the whole variety of other financial assets. Moreover, the ongoing recession (is it too early to call it that?) is perhaps the largest since the crypto dip of the winter 2017–2018, yet much more substantial in the total amount of wealth lost, for the obvious reasons. In addition to the crypto market, the NFT market has emerged too, which was not a thing ‘back in the days’. And nowadays, after everyone got used to the idea of the cryptos being more volatile than the, so-called, regular financial assets, the focus has shifted towards the newcomer, NFT market that is. While some are still confused what NFTs represent, others launch a barrage of criticism on the whole concept of NFTs — a well-established tradition of the unwelcoming world of bully-like financial “gurus”. Needless to say, the slow adapters of the new realm of finance (and technologies for that matter) were thrilled to elbow the peers in publishing their ‘I told you so’ in big headlines like «NFT sales plummet 92% as market ‘collapses’» .
While it is tempting to smash the keyboard while foaming at the mouth in writing disproving arguments, we shall focus on a different topic. In fact, this article would be a logical continuation to the Part 1. As we promised, this part would be more entertaining, as would look into the psychology of financial decisions and would bare the uncomforting irrationality of human minds.
First of all, as the tradition demands it, let’s briefly indicate why the topic of behavioral finance is important and should be considered with all seriousness. When evaluating a financial asset, we allegedly act as rational beings, completely fencing ourselves off the emotional attachments. Is that really so? Really, when was the last time you looked at something and thought ‘well, it does seem a bit expensive…but I have that gut feeling’ — exactly. As much as we wish to deem ourselves as truly pragmatic creatures, we are far from being self-composed calculating androids. Otherwise, why would it be a standard to use $0.99 instead of the logical $1 — a well-known, researched and documented trick in marketing and sales.
Essentially, behavioral finance in the amalgamation of conventional psychology and financial analysis, which aims to deconstruct some of the psychological biases and heuristics that affect financial decision-making. Right, let’s get started with some of them, shall we.
- Anchoring bias
One of the simplest, yet, perhaps, the most prominent of the bunch. Fundamentally, it refers to one’s mental attachment to a certain price in situations where this price, acting as an anchor, should not be used any longer. For instance, if you purchased an NFT for $100 and were able to sell it at the market’s peak for $1000, you most likely have these two figures imprinted mentally as the anchors. This way, if the current market price for this NFT is $80, you are likely to perceive the market-established price as unfair, unjust and simply wrong. While a cold-blooded approach would be to consider the actual intrinsic value of owning this NFT, your anchoring bias would tell you that the very minimum this NFT is worth should be around $100. But, most importantly, in the price-changing environment, the most likely anchor would be $1000 since at some point you could have sold it for that much. We often call such situation as the regret of missing the opportunity, when in reality it is an anchoring bias. Moreover, anchoring bias can present itself in the form of willing to make a certain profit as we have already assigned the money to something else, like looking to sell such and such NFTs for an X amount because the new car we want to buy costs exactly that. - Confirmation bias
This refers to one’s predisposition to seek news and facts that further prove the existing beliefs and place more weight on such news. So, assume you are already involved in a project, thus already have a subjective view of it. You then find out 1 piece of positive news that favour the project amongst the other 9 negative news. Logically, and let’s assume these news have the same magnitude, the final outcome is still 1–9= -8. However, the confirmation bias would not allow such thinking and would rather replace it with ‘see, there are good news, it will go up in price!’. If you think you are immune to this, just consider the last time some positive rumours about a project convinced you to invest, as opposed to the reality and negative facts about the same project. - Halo effect
As the name suggests, this cognitive misconception forces one to assign unknown or unconfirmed positive traits based on other known positive traits. This bias is closely linked to stereotypical thinking: if a person has tattoos, does yoga and cares about nature…it does not automatically make the person a vegan, yet many would jump to this conclusion. Essentially, it is the extrapolating process of positive features based on completely unrelated features known to us. Imagine liking the work of some famous singer, let’s say Paty Kerry, and hearing about the launch of an NFT collection. The halo effect would automatically force us to think that this project is going to be the next big thing and we should definitely enter it. However, in reality, we would need to look at the facts, the white paper, the team and many other factors to determine whether the project is a good fit for us. Halo effect has a sibling too — horn effect, that is, creating negative conjectures based on the personal dislike or previous negative impression. You might not like a certain brand for its design, yet their NFT collection could be an extremely lucrative investment, strictly financially speaking, not the art form. Remember all the criticism about the Order of the Tigons collection based on the dislike of the art? - Mental accounting
Well, this one is straight forward, sort of. It is the difference in treating the money based on what they are assigned to or their source. We are all subject to this heuristic, no exceptions. A simple proof: buying a pair of shoes of a brand unfamiliar to us for $300 is expensive, yet getting a pair of Dior sneakers for the same price is a good deal. We mentally assign different values to these two pairs of footwear, even though the quality, therefore the intrinsic value, might be the same. While in this example, any economist would find a flaw in logic, as the utility curves (utilitarian gratification of ownership) can vary greatly for these different products, (or one might simply argue for the intangible value of a recognizable brand and the associated pride) the real problems come when the mental accounting is involved in the source of income. So, consider a $1000 NFT. If you were to buy it with the hard-earned money it would not feel the same way as buying it with the money made on a previous lucky NFT flip, would it? That is why we often witness irrational and even dumb financial behavior of lottery winners, who purchase totally unnecessary things and essentially burn through the cash just to return to their prior way of living. Their mental accounting fails them, as the money unexpectedly won in a lottery was not a hard gain; therefore, they are ready to part with the money much easier. Next time you consider buying a new NFT, especially a rare one, please ask yourself a question “would I buy it if I had to save up for it from a grueling job?” - Bandwagon effect a.k.a herd behavior
Many have perhaps heard about this psychological defect in our conduct, but usually in the context of daily routine. This bias merely describes the salient tendency of humans to like what their peers like; starting from a young age when children play the same toys and have the same ‘cool’ hobbies to the very adulthood of having to take interest in what is dictated by the majority as being fashionable. At this point, we shall omit the deeper need of self-actualization and the sense of belongingness to a group and the philosophical role of an individual in a society. Nevertheless, when it comes to financial decision-making, NFTs included, many simply choose a project based on what their friends or internet idols like. Needless to say, investment is a financial mechanism in the first place, not some book study club for socialization.
Often the story behind the name of the Bandwagon effect is attributed to the sensational popularity of VW’s Bandwagon, which was deemed as uncool at the start of the sales in 1960s, but later acquired an immense popularity amongst surfers. This image of being a part of the surfer society later translated into a wide-spread demand, as more people possessed the Bandwagon, the more people wanted to get one.
There were some of the more prominent psychological biases in finance, yet the list can be continued to include topics like self-serving bias, regret aversion, hyperbolic discounting, hindsight bias and many, many others. In fact, the idea of this article is to showcase a few possible flaws in our decision making process, especially when it comes to financial evaluation of NFTs in the context of the first part. Moreover, knowing these biases and heuristics arguably gives an advantage of being able to test ourselves with the right questions. Nevertheless, knowing these and even being able to accurately spot them does not guarantee an unbiased outcome of our resulting decision. It is merely a tool that can assist in making better decisions. In the end, as the famous saying goes “forewarned is forearmed”.
N.B. the topics of the crypto and NFT markets recession, oversaturation of the NFT market etc. certainly loom in the air and we are currently considering the next part of this mini-series to be solely focused on the market as a whole. Stay tuned!
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