Become a smarter trader: 5 mind traps to avoid

According to classical economics, people are rational — driven by logic and common sense. Yet this is not always the case. All too often, crypto traders fall victim to mental hang-ups as old as human civilization. Learning about these traps is the first step toward a better financial future.

What are cognitive biases?

All decisions involve uncertainty, and we use unconscious shortcuts to understand how to proceed. The term “cognitive bias” was introduced in the 1970s by Amos Tversky and Daniel Kahneman to describe such systematic errors in thinking. They are studied extensively in behavioral economics — a fusion of economics and psychology focused on how and why people behave the way they actually do.

A rational investor would always make decisions aligned with their best interests. The reality, however, is quite different. The human brain is lazy, emotions taint our perception, and the longer we cling to something, the harder it is to let go. Here are five ways your brain may prevent you from achieving more with your crypto holdings.

#1 Confirmation bias

It feels good to be right, and we all seek information supporting our preferences and beliefs. Confirmation bias is everywhere. It explains why pessimists ignore positive events, Republican voters pick FOX News over MSNBC, and horoscopes are still popular.

In finance, this mental trap causes the buildup of extreme fear and greed. Financial advisors who took part in the BeFi Barometer 2021 study included it in the top behavioral biases affecting their clients’ decisions.

Investors who discount bad news may overvalue some assets, rendering their portfolios more vulnerable to company- or sector-specific downturns. Then, when things go south, they feel blindsided.

Think about the way you consume market news. Are you getting enough data to make informed decisions? What is your motivation for trusting some experts over others? Any time you find yourself absorbing a one-sided narrative, confirmation bias is at play. Gathering a healthy array of viewpoints is key for drawing balanced conclusions.

Confirmation bias is also salient in interpreting failures. For example, take the fallout from the 2022 FTX collapse. As noted by Architect CEO Brett Harrison, humans may learn crucial lessons, but they may also draw very different conclusions. The same event may be used as proof that regulators must audit crypto firms or eliminate all blockchain-based assets.

#2 Social proof

Greek philosopher Aristotle said, “Man is by nature a social animal.” We rely on others to thrive and survive, and it is natural to seek guidance. It is also tempting to follow the crowd — if many people are doing the same thing, you may presume they possess some sacred knowledge.

This bias, sometimes called the “Bandwagon effect,” underlies speculative bubbles. In the worst cases, people rely on others’ opinions fully without a shred of independent research.

Crypto is salient on social media, but think twice before taking some random tweet or Facebook article on faith. DYOR (Do Your Own Research) is typical advice for crypto traders, and for good reason.

Poor analysis is only part of the problem. Where real money is involved, scams and misinformation abound. Some of the so-called “crypto experts” are shills — paid influencers who pretend to endorse a specific cryptocurrency in good faith. Don’t let them fool you — always conduct your own due diligence.

Like all biases, social proof may also affect businesses. That is why reputable platforms perform all-round assessments before listing new tokens. They cannot afford to trust the hype.

#3 FOMO (fear of missing out)

Shillers artificially the prices of specific tokens. When an asset gets a lot of hype, potential investors feel undue pressure to buy into it. They fear they might miss out on a profitable investment. After all, the grass is always greener on the other side.

FOMO is closely related to social proof and herd mentality. Research shows that it is the most prevalent in people aged 18 to 35. This bias prompts investors to make counterintuitive moves — for example, buy a coin at a high or sell at a low, rather than vice versa. Such capital decisions not only cause financial damage. They may affect one’s mental health, relationships, and quality of life overall.

In a recent social experiment, a Twitter user known as Voshy announced an airdrop for a nonexistent token called GREED. Within hours, his follower count exploded, and he was bombarded with requests from buyers.

Around 43,000 Twitter users failed to do any research. Furthermore, they blindly followed his instructions, giving access to their accounts and wallets and tweeting ridiculous statements. Copycat accounts started to pop up. Eventually, Voshy even had to mint actual GREED tokens to prevent followers from getting scammed.

#4 Sunk costs

Suppose a coin in your portfolio is 70% down in value. Would you still cling to it or sell it and invest that 30% elsewhere? Those who choose the former may be affected by another bias — over-committing out of fear of losing the original investment.

You are reluctant to back down — selling is admitting you have made a wrong decision. This proclivity is also connected to the endowment effect — placing a higher value on something we already own. Ask yourself, “If I didn’t own that coin, knowing what I know now, would I invest in it today?”

Sunk costs make us clutter our homes with useless things, finish meals when we are already full, and throw good money after bad. They drive up prices in auctions, keep failed governments alive, and even fuel wars.

Interestingly, this propensity is typical for adults but not small children or lower animals. The truth may hurt, but regret is a gift. When efforts are fruitless, it is best to admit this and stop than persevere. In crypto, people tend to ignore losses or consider them unrealized.

#5 Loss aversion

Losing money is painful, and so is giving up anything we own. Faced with a threat of loss, our brain prioritizes avoiding it over maximizing opportunities. Since the dawn of time, this imbalance has helped organisms pass on their genes.

The prospect of losses eclipses the promise of gains, preventing us from treating the two equally. Shrewd marketers exploit this bias by convincing us that what they sell is worth more than its price. Meanwhile, people offered a gamble are more likely to accept it if the possible payout is around double the potential loss.

According to some studies, the psychological pain of losing is about twice as powerful as the pleasure of gaining. In finance, this phenomenon causes irrational decisions, such as holding onto an asset for too long or too little time.

When taken to extremes, this approach becomes a negative bias. Investors may zoom in on bad news, becoming fixated on foreseeing a bear market. This tunnel vision may result in missing out on bullish phases and panicking during sell-offs.

Key takeaways

Dan Ariely, a leading expert on behavioral economics, wrote, “We are all far less rational in our decision-making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless: they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains.”

However adept we become at recognizing mental shortcuts, they will always be part of human nature. Of course, we cannot un-bias ourselves completely, but we can dissect our motivations before failing again.

It is easy to become emotional on the spur of the moment. In finance, letting feelings get the best of you has a price — sometimes, an extremely high price.

Reflect on past mistakes to see if cognitive biases were at play and have a checklist with time-tested criteria for each decision. It won’t make you infallible, but it could prevent some impulsive missteps.