The field of behavioral finance, which combines the study of psychology and finance, teaches us that there is a range of cognitive biases that can can affect your decision-making process when it comes to making investment decisions.
To help you to prevent yourself from making avoidable trading losses, you will learn about the ten most common cognitive biases that can affect your cryptocurrency trading in this guide.
Confirmation bias refers to the tendency to search for or interpret information so that it favors one’s preexisting opinion or belief. In cryptocurrency trading, this can be an issue for investors who end up blocking out negative news or opposing views about a purchased coin or token on an unconscious level. This can lead to suboptimal trading decisions and, hence, needs to be something that investors are aware of.
The anchoring bias is another cognitive bias that regularly occurs among investors. The anchoring bias refers to the use of initial or irrelevant information as a reference point for attributing value.
In the investment space, anchoring can negatively affect portfolio value if the investor holds onto an investment longer than necessary by using the initial purchase price as an anchor or by setting his or her price targets at levels that carry no market-relevant significance, for example.
Optimism bias refers to a cognitive bias where a person’s belief is that there is a smaller risk of a negative outcome than a positive one. This is actually a cognitive bias that is rampant in the cryptocurrency investment space, where investors’ enthusiasm – especially about small altcoins – can often far exceed reasoning, fundamental values, and hard facts.
The general optimism in the crypto asset investment community may not be entirely unfounded in light of the historic price performance of the asset class. However, it is important to look at the fundamental values, news flow, and other market forces and not base one’s investment decisions purely on the optimism and hype created by the cryptocurrency investor community.
Overconfidence is another cognitive bias that regularly occurs among investors. Studies have shown that most investors are overconfident about their abilities to make smart investment decisions. This can especially be an issue in a bull market, as we have witnessed in the past few years in cryptocurrencies, as it can lead investors – especially newcomers – to believe they are better investors than they actually are. This, in turn, can come to hurt them in a prolonged bear market or during times of extreme volatility.
The gambler’s fallacy, also known as the Monte Carlo fallacy, occurs when a person thinks that something is less or more likely to occur in the future given a previous series of events. However, this is incorrect. Past events, especially in the investment space, do not relate to future outcomes.
Falling victim to the gambler’s fallacy can cause losses for investors if they believe a coin will go up simply because it has gone down for several days, for example.
The bandwagon is a cognitive bias that leads people to perform a certain action, regardless of their own believes, mainly because others are doing so. This phenomenon is more commonly referred to as FOMO (fear of missing out) in the cryptocurrency markets.
To avoid the FOMO trades, it is important to make trading decisions based on research and thorough due diligence and not because others are buying a specific digital asset and are raving about how much it will go “to the moon”.
In behavioral finance, the endowment effect refers to a cognitive bias that leads investors to value an investment or a specific asset more because they already own it than those that they do not own (yet). In other words, people have the tendency to value something more simply because they already own it.
As a cryptocurrency investor, building a diversified portfolio and choosing the right crypto assets to buy and sell is key to success. Hence, it is important to avoid this bias as it can prevent one from purchasing potentially profitable new digital assets.
The halo effect is cognitive bias in which the brain allows a person, an idea or an object’s specific positive traits to positively influence overall evaluation.
In the cryptocurrency space, the halo effect occurs when an investor “falls in love with a coin”. This can lead to the investor neglecting negative aspects or news related to this digital asset, which could be valid reasons for exiting the position.
Mental accounting is a cognitive bias that suggests that people classify money differently, which can lead to irrational financial behavior.
This occurs most commonly with funds that have been gifted or won. As they are often seen as “free” or “extra” money, this leads to investors placing riskier trades with their earnings than they would with their initial investment capital.
Irrational exuberance is a phenomenon that occurs when investor enthusiasm is driving up asset prices to levels that far supersede the fundamental value. This is something that can be clearly found in the altcoin market, where coins with little to no real-world utility reach market values of several tens of millions of dollars despite the fact that there are much better alternatives in the market.
While everyone has cognitive biases on some degree, as an investor in the cryptocurrency space it helps to be aware of them so that you can catch yourself making unnecessary trading mistakes before you clicking the ‘buy’ button.