The Psychology of a Bag Holder- An Analysis
We’ll go into studies, effects, and theories underlying the popular term within cryptocurrency known as a “bag holder”
What is a Bag holder?
The popular term refers to the tendency of an investor in a decreasing stock or asset to hold their position until it ultimately becomes worthless. In most instances, the investor will hold such position until nearly all initial capital is lost. This creates the symbolic term “bag holder” for someone who is essentially clinging to a single “bag of stock” or within cryptocurrency, a single crypto asset usually other than bitcoin.
Example: John Doe buys X tokens of Project Y. Following a successful ICO and excessive marketing, Project Y skyrockets in value. Then there is a delay in their product and bad PR begins to ensue. An analyst finds their idea is not sustainable and team is not as experienced as they were led to believed and this causes the token price to drop and decrease steadily. John Doe chooses to ignore all these signs and indicators by “believing in the project” and subsequently becomes a bag holder.
So, the question we must ask ourselves is who in the world is crazy enough to hold steadily decreasing assets or more importantly, why do they hold them?
Psychological Effects
Much like within traditional markets the term bag holder is fairly popular, however more so within cryptocurrency. Following the ICO craze that was experienced last year, combined with exuberant optimism there are still to this day many bag holders that exist. These people are holding “bags” of crypto that have dropped significantly in value, many greater than 90%. Rather than taking profit when times were good, these people ignored all signs and indicators around them and clung to a single crypto asset other than bitcoin.
It’s a truly interesting phenomenon, which I will go into greater depth about following a brief example of a crypto bag holder.
Here we see our first exhibit we’ll call it exhibit A, who appears to have clung to a single project all the way from 10 cents to $2.48, wow that’s a good ROI! A perfect mountain formation has been formed, the price of the asset went parabolic and went exactly back to where it was originally. This person represents the epitome of bag holding at the core, hopefully they took some profit.
However, Rekt Plebs is a channel dedicated to bringing forth publicly several instances of bag holding and a series of unfortunate financial circumstances. Exhibit A shows us the mentality of some people within crypto who believe their tokens will continue to rise, but ignore any and all indicators around them that cause the token to lose value.
While many may be speculative, this particular project has delayed their original V1 product scheduled for December 2017/Early 2018, faked a major partnership, have a major security issue within their smart contract, and also are doing a second ico because of poor treasury management.
Yikes.
Disposition Effect
The disposition effect is an anomaly that exists within behavioral finance studies. In short, it is the way investors tend to treat unrealised losses and gains on financial assets. There is a very thorough and in depth case study on this particular topic.
Nicholas C. Barberis of Yale School of Management and Wei Xiong of Princeton University Bendheim Center for Finance, have noted and described the effect as “one of the most robust facts about the trading of individual investors.”
The effect, which they note “has been documented in all the available large databases of individual investor trading activity and has been linked to important pricing phenomena such as post-earnings announcement drift and stock-level momentum. Disposition effects have also been uncovered in other settings — in the real estate market, for example, and in the exercise of executive stock options.”
Barberis goes on to further explain how it is a not a rational form of conduct amongst investors due to the reality of financial markets momentum. This is explained in greater depth as simply the fact “that stocks that have done well over the past six months tend to keep doing well over the next six months; and that stocks that have done poorly over the past six months tend to keep doing poorly over the next six months.”
Conversely, the rational act that would be performed is “to hold on to stocks that have recently risen in value; and to sell stocks that have recently fallen in value. But individual investors tend to do exactly the opposite.”
From the disposition effect we can glean not only the rational conduct or lack thereof that exists within individual investors, but we can also correlate a similar theory known as the Prospect Theory which explains individual investors disposition to “ride losers”.
Prospect Theory
The prospect theory assumes individuals make decisions based on perceived gains instead of perceived losses. At the core, the general concept is put into two choices presented to before an individual, with one presented in terms of potential gains and the other presented in terms of possible losses. The first choice will be chosen.
In one of the key insights from Behavioural Finance, the nobel prize winning Prospect Theory of Kahneman and Tversky can be neatly explained by the graph below.
As per the chart we can glean utilizing the prospect theory and it’s framework for framing risky choices and indicates that people are loss-averse; since individuals dislike losses more than equivalent gains, they are more willing to take risks to avoid a loss.
It also illustrates, among other things, some of the non-rational decisions we make as we are guided by emotion and heuristics in decisions.
- Loss aversion — the different shape of the curves as we make gains or losses represents how a loss of $500 annoys us much more than a gain of $500 gives us pleasure.
- Diminishing sensitivity — the leveling off of the curves represents that we’ll enjoy winning $500, if we only have $500, much more than we’d enjoy winning $100 if we had $1000.
- Adaptation level — We don’t evaluate from some absolute level, rather we evaluate whether something is good or bad from a neutral reference point that we adapt to. So, by the end of a movie the movie theater doesn’t feel dark, yet walking out feels blinding. One’s reaction to the $500 example above was probably affected by whether they think $500 is a lot of money or a little, which is all to do with ones adaptation level.
Sunk Cost Fallacy
The sunk cost fallacy is another reason why an individual investor may become a bag holder.
Sunk costs are costs that have already occurred and cannot or very unlikely to be recovered. For example, a individual investor purchased 1000 tokens of Substratum at $0.10 for $100, the tokens fell in price to $0.04. The market value of the tokens after falling to $0.04 is just $40. The $60 lost is a sunk cost for that point in time.
Many investors are tempted to hold on to their asset and wait for it to at least go back up to $100 market value, however the losses have already became a sunk cost.
Furthermore, many investors hold on to a stock or crypto asset for too long because it’s an unrealized loss or “paper loss”, which simply means it’s not reflected until the stock or asset is actually sold. In some cases, this encourages investors to perceive an opportunity that prices will recover.
Conclusion
Bagholder is a term used to describe someone who holds a position in a asset until it decreases in value and becomes completely worthless. Bag holders often succumb to the disposition effect or sunk cost fallacy, which often makes them hold positions for too long.
Disclaimer: I am not a psychologist nor do I have an extensive background in behavioral finance. The internet is a vast world of information and I wanted to explore why people “baghold” assets until they drop in value and ultimately become completely worthless.
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