The Greek philosopher Heraclitus once said, “No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.” The same can be said about people and financial crises.
Digital asset prices have crashed as a result of the COVID-19 pandemic despite the belief that it was a ‘safe-haven asset.’ The cause for the crash, in short, is a combination of human and technical factors. People sold and the price drop triggered further selling due to margin calls, the same way it happens in every other actively traded market.
COVID-19 has quickly spread across the world and derailed daily and economic life along with entire asset classes. We don’t know the extent of the damage it will cause for some time but amidst the uncertainty, ambiguity, and chaos, we can look at behavioural finance to help digital asset investors make intelligent investing decisions during this difficult time.
Amidst the uncertainty, ambiguity, and chaos, we can look at behavioural finance to help digital asset investors make intelligent investing decisions during this difficult time.
A (notably brief) history of financial crises
Financial crises date back to the first century when in 33 A.D. when unsecured loans initiated a financial chain reaction in the Roman empire, and since then crises have continued until today in various forms and magnitudes. The most recent financial crisis in 2008 had many wondering if it was a repeat of the 1929 crash and ensuing Great Depression. As Mark Twain wrote, “history doesn’t repeat itself, but it often rhymes”, as a banking crisis sent shockwaves through the economy yet the economy at large remained intact, partly because the world had changed dramatically since the Great Depression and evolved, such as instating regulation requiring increasing margin requirements for stock ownership and the formation of federal entities such as the Federal Deposit Insurance Corporation intended to prevent similar events from happening again.
Even if similar events were to occur as they did in 1929 or 2008 (or 33 A.D. for that matter), they would not unfold the same way. Today regulators have different tools, the interest rate floor is historically low, and people think and feel about money and investing differently. In other words, historic context is important, but may have limited utility in predicting how things are going to go, especially in the current crisis with so many unknowns about the impact on human life and society. As with most crises, the digital asset crash and new unknowns bring up core questions about its relative value, function, and what people should do during extreme uncertainty.
Connections between equities and digital assets
Many people invest in digital assets because of their innovative underlying technologies, while some believe in the disruptive nature of decentralized finance, and others believe a digital asset is a store of value and likely to rise in price over time. Up until recently, digital asset returns were largely uncorrelated to the returns of other types of assets leading many to argue for their inclusion in investment portfolios.
The hypothesis of value storage under duress has not been meaningfully tested because the equities market had been on an epic eleven-year bull run, so there was no opportunity to see whether people fleeing to safety would choose digital assets as their relatively safer asset. The recent price drop following the crash in equities, fixed income, and other asset types has led many people to conclude that a digital asset is not a safe haven asset.
The economic reality of digital assets
These conclusions must be contextualized for this particular crisis. The typically safest assets — bonds, treasury bills, and gold — are also being abandoned by the public and many types of funds in favour of fiat currencies (USD primarily). Faith in even the most benchmarking institutions has been shaken, so it is premature to conclude that the flight to fiat is a clear and permanent reflection of digital assets as a safe asset. It is also important not to conclude prematurely, as the recent price crash does not mean that digital assets will not rise during crisis, it simply means that in this particular time period people chose to sell. In fact, we see that despite the DJIA and S&P convulsing downwards over the past few days, digital assets are actually increasing despite the increasing risk and uncertainty regarding the virus and its ramifications.
Further, it depends on what is meant by “safe.” If safe means that the price never crashes or varies significantly, then there is no safe asset on the planet. However, if safe is a quality of the asset in that it continues to perform its function without collapsing during duress, then digital assets are standing the test of crisis.
It is important to remember that bitcoin is a currency produced via computer mining operations run by people and carried out by machines. This fact grounds digital assets to economic reality in the same way that airlines and restaurants are subject to economic and social forces. Part of the co-movement in price is due to the fact that the same economic forces that affect other types of firms also affect mining companies and their ability to operate profitably.
Also, there could be another contributing cause to the crash: opportunistic price manipulation. Crises present opportunities due to the fact that many previously constant aspects become variable. A deliberate selloff of a digital asset to initiate and/or exacerbate a crash may provide opportunity, yet exacts a potentially significant cost to the entire ecosystem by destroying the portion of value held by the belief of the asset as value storage.
Apart from the current crisis, despite the crash, there is precedent of prices of early innovative new markets crashing and their value becoming clearer over time (hint: you’re using its products right now). From the ashes of the technology crash of 2001 rose today’s largest companies, such as Apple, Google, Amazon, and Adobe. Likewise, digital asset prices falling and the inevitable consolidation among competing coins are part of the natural industrial innovation lifecycle. This process vets a new and innovative technology by testing its fundamental value against economic laws in the commercial world.
Digital asset prices falling and the inevitable consolidation among competing coins are part of the natural industrial innovation lifecycle. This process vets a new and innovative technology by testing its fundamental value against economic laws in the commercial world.
Knowing the precise reasons why prices crashed helps us to some extent, yet many are still faced with the reality of a highly volatile market and uncertain future. Let’s go through a few concepts in behavioural finance that may provide some structure and guidance, starting with the thinking processes we use and how they can get us into — and out — of trouble.
System 1 vs. System 2 behaviours and investing
One of the learnings from the 2008 crash was the importance of being able to differentiate existential from non-existential threats. Those who were able to recognize a banking crisis for what it was, estimate the outer edges of its systemic damage, and purchase assets at periods of extreme uncertainty were rewarded with outsized returns. The same applies now in digital assets and can help us to think more clearly about this crisis.
From research in neuroscience, cognitive psychology, and behavioural economics, we learn that people have two general ways of thinking and navigating through life, Systems 1 and 2 (Nobel Prize winner Daniel Kahneman writes about this eloquently in his book Thinking, Fast and Slow): Automatic and reflex-based responses come from System 1 while observing, considering, weighing, and reflecting on the situation before acting are based in System 2.
There are situations where System 1 is ideal, such as competitive sports, rapid real-time trading, and improvisation. However, most complex decisions in life are best thought through to get optimal results. In my own research, I have found that the ability to inhibit automatic behaviours and act rationally differentiates between people’s performance and how much money they can earn in economic experiments. The same principles apply outside the lab to investment decisions.
It does not matter to our System 1 what the underlying technology is or what the shrinking numbers on our trading account represent — when most people see value disappear, they panic and sell. People do this without thinking through whether the current price is above or below the long-term expected value of the asset or deep analysis of discounted cash flows. It is perfectly normal to feel fear in extreme situations and panic when uncertainty is at its peak, which is precisely why people sell at the bottom because they feel that the sky is falling and catastrophe is nigh.
Just as sophisticated investors, hedge funds, and holding companies did during the 2008 crisis, think through and work to differentiate reality versus your reaction to news, opinions, and fear. A good System 2 approach is to seek high-quality facts from credible sources regarding various scenarios and how they could unfold, assign logical probabilities to them, and act accordingly. Before making any meaningful changes to your portfolio, ask yourself whether the value of the product, service, or asset has fundamentally changed or not. We ought to think through whether digital assets are in a genuine crisis of existence or suffering a crash from a system-wide panic. The collective risk is exacerbated when people collectively react in System 1 because it worsens the situation.
Herding vs. Sticking to your guns
In times of heightened uncertainty, people not only not think clearly but they follow others’ behaviour more automatically. Herding behaviours kick in when people see others acting collectively such as buying toilet paper or selling stocks — which further fuels the very problem the behaviour was meant to solve. Even when people have their own beliefs, they toss them and adopt others’ views in a process known as information cascades If this sounds familiar, it’s because most of us do it when we don’t know what else to do and is innate to us as humans.
This behaviour makes sense in the moment if you are holding assets in a crash because you feel afraid and don’t know what to do, so impulse often takes over and sell to stop the negative feelings. We do this automatically, not because we believe that to be the best action in the long run. The challenge is even greater when we are already stressed and worried as our very emotional states themselves can push us to be even more reactive over time.
Applying the right mindset to investing
Every successful investor needs to occupy two worldviews at the same time. Anyone invested in financial markets who wishes to succeed should learn to live in the world of typical people who act based on emotion and in the world of mechanical relationships and cold facts.
Economist John Maynard Keynes once famously said that doing well in the stock market is like predicting the winning contestant in a beauty pageant: you should choose the one you think the judges will choose, not the one you think should win. This is an example of theory of mind, where you think what others are thinking. This relates to herding and information cascades because they influence most people to act in predictable ways, and the intelligent investor can inhibit their automatic reactions and capitalize on the outcome. We at Bayesian Group use behavioural finance as a framework for understanding markets and in calibrating the optimal measured response to them.
Another key differentiator between success and failure can be found in the ability to think clearly in times of crisis, and distinguish between factors that are within your control from factors that are not.
Investing is a continuous journey
Many digital asset investors are disappointed that digital asset prices dropped along with all other asset types, yet it is important to keep in mind that this occurred as part of a systemic panic and that crash prices do not necessarily reflect a corresponding change in the value of the assets. There are multiple reasons for why prices crashed, but unlike the value of mortgage-backed securities in 2008, digital assets did not suffer a fatal blow to their utility or impairment of their intrinsic value.
People in financial crisis generally act as if they are drowning and flail and grasp at objects, any objects, to feel safe. This reflex may help survive falling out of a boat but generally isn’t effective on dry land. Cultivating the ability to withstand the discomfort of loss in order to avoid causing further losses is crucial in investing. Moving from reactivity and fear to thinking through an investment decision can differentiate between failure from seeking short term relief and long term success in finance and many other areas of life.
We can seize the opportunity to grow from crises by learning about ourselves and human tendencies in financial markets. By doing so, we ourselves can evolve and change so that we are better prepared next time we step into the proverbial river.