Behavioural Economics and Finance - Essential knowledge for any serious crypto trader

Why do people sell winning investments and hold onto losing investments for far too long? Why do investors ignore some information when making investment decisions, but place an over emphasis on other information sources? Why do seemingly intelligent people often make terrible investors? Isaac Newton, the father of gravitational theory and one of the most intelligent people ever to walk the earth, lost millions in the share market. Traditional economics assumes that all economic decisions are made rationally. Real-life experience demonstrates that most people behave irrationally when making decisions of all types. Behavioural economics, and its subset, behavioural finance, attempt to explain how irrational behaviour can affect the decisions of investors in financial markets.

The reason that this is such an essential knowledge for any crypto investor or trader is the fact that every human being falls victim to the mental shortcuts and other decision-making processes studied by behavioural economists. Without a well formulated plan to combat these biases, investors are likely to achieve subpar performance. I have touched on this issue in some of my previous posts, most recently, A Rising Tide Lifts all Boats, but the implications of behavioural finance extend far beyond simple investor overconfidence. This article will attempt to outline some of the basic principles of behavioural finance, and if there is sufficient interest from my readers then I will elaborate further in later posts.

Behavioural Finance

According to conventional financial theory, the world and its
participants are, for the most part, rational "wealth maximizers".
However, there are many instances where emotion and psychology
influence our decisions, causing us to behave in unpredictable or
irrational ways.

Behavioral finance is a relatively new field that seeks to combine
behavioural and cognitive psychological theory with conventional
economics and finance to provide explanations for why people make irrational financial decisions.

Albert Phung -Investopedia

According to behavioural finance theory every human is subject to a number of cognitive flaws that prevent them from making optimal decisions when risk is involved. These cognitive biases, or subconscious shortcuts (known as heuristics in the language of psychology) are the result of millions of years of human evolution.

In the days of the cavemen, humans did not have time to make well-reasoned and thought through decisions when faced with risk. The human brain developed a number of shortcuts for dealing with risky situations that maximised the chances of the survival of the species.

The problem we face today is that the mental shortcut that was appropriate for dealing with the risk of being eaten by a sabre tooth tiger, is extremely unlikely to also be appropriate for dealing with risk in a financial setting. This means that unless you are very disciplined in your approach to your trading, you are likely to unconsciously make poor decisions, based on mental shortcuts that you did not even realise you are taking. Some examples of common anomalies studied in behavioural finance are as follows

Prospect Theory -Loss Aversion

This is considered to be the original theoretical foundation of behavioural finance and is based on the work of Daniel Kahneman and Amos Tversky, which was published in 1979. Kahneman was awarded the Nobel Prize for this piece of work. In a nutshell Prospect Theory has identified that people fear losses much more than they value gains. A common estimate is that people fear losing money almost twice as much as they appreciate gaining rewards. In a real-world example this means that you will feel the pain of losing 100 dollars twice as intensely as you will feel pleasure from making 100 dollars on any given investment. This leads investors to make irrational decisions in relation to their investments, and can significantly hamper the performance of an investment portfolio. A common example attributed to Prospect Theory is the failure of investors to sell losing investments. Anybody who has been investing for any period of time will have some form of investment that has gone poorly, and which they have held onto for far longer than they should. Even though we know we should sell this particular investment, we still hold onto it in the hope that it will one day recover. Prospect theory would explain the failure to sell as a fear of realising a loss, which is something which your average investor is particularly averse to.

Anchoring

Anchoring is a concept found not just in behavioural finance, but also in many other fields, one of the most prominent of which is marketing. Anchoring theory states that people often base their decisions on the first source of information to which they are exposed. To give a marketing example of anchoring one only needs to look at the recommended retail price listed for most retail consumer electronic goods. If you visit the Sony or the Samsung website and look at the recommended retail price of any product, the price quoted will be significantly higher than what the item can be bought for either online or in store. By anchoring the client’s expectations at a higher price, the marketer has effectively made the actual purchase seem like a good deal when the consumer sees the item advertised for a lower price elsewhere. This type of marketing trick is used everywhere from selling televisions and cars, through to selling houses.

In financial markets anchoring is most relevant to the price of the investments that we buy and sell. If you first examine a particular crypto coin and its price is one dollar, then subconsciously your mind registers one dollar as an anchor price for that investment. If the price doubles from one dollar, it seems like the coin has suddenly become expensive. If it falls by half from one dollar, then it seems like the price has suddenly become cheap. All of this is completely divorced from the reality of whether or not one dollar was actually a fair price for that investment in the first instance. Anchoring can prevent an investor from entering a trade after a period of price appreciation because they will be anchored at a lower price for fair value.

Anchoring can also combine with Prospect Theory to convince investors to hold losing investments longer than they should. Many investors will have heard a friend or colleague say that they are simply waiting for a particular investment to recover to the price at which they purchased it before selling. This is an example of anchoring. The investment may never have been worth the price that the investor paid, but in the mind of that investor, the price is anchored at his initial purchase price and s/he will hold that investment until either it becomes valueless, or it recovers to his original price. In many cases loss-making investments will become valueless and the investor will be significantly out-of-pocket. Being aware of the concept of anchoring and how it can affect your investment decisions can significantly improve your trading outcomes.

Overconfidence

In the 1980’s, a study of US drivers was done in which 70% to 80% of drivers reported themselves to be safer than the average driver on American roads. I heard the results of a similar study that showed that 100% of men believe themselves to be better than average at sports. Simple reflection will show that neither of these statements are possible. Only half of a given population can be better than average at any given skill. So when somewhere between 70% and 100% of participants in surveys are indicating that they believe that they are above average, we have a classic example of overconfidence.

Overconfidence leads to a second bias known as self-attribution bias, whereby investors attribute positive outcomes in investments to their own skill, whilst blaming market conditions for any negative outcomes that they may obtain. This has many flow on effects, including overly risky behaviour, as investors believe themselves smarter than they really are. Over trading is another common manifestation of this trait as investors try to take advantage of their “skill.” Numerous studies have shown that the more often an investor trades, the less profitable they become, so overconfidence can significantly reduce your trading profits if it is left unchecked. Men are, unsurprisingly, much more susceptible to over confidence than women.

Confirmation bias

For an investor. confirmation bias is one of the most dangerous manifestations of cognitive bias. Confirmation bias is defined as:

A psychological phenomenon that explains why people tend to seek out information that confirms their existing opinions and overlook or ignore information that refutes their beliefs.

Investopedia

The most common manifestation of confirmation bias in investing is when assessing the merits of a particular investment. Investors will actively seek out information sources that confirm their pre-existing opinions, and will either ignore or discount any information that contradicts their beliefs. This is very dangerous to a potential investor as you are likely to unconsciously overlook significant pieces of information that may be relevant to making an investment decision. A very simple mechanism to overcome confirmation bias is to actively seek out pieces of information that contradict your own opinion. So, if you think a particular coin is a great investment, actively seek out articles and other sources that that state otherwise. Once you become familiar with this bias you will become aware of it in your day-to-day investment decisions. When scanning newsfeeds of investment articles, you will find yourself passing over articles that disagree with your particular point of view and will have to consciously force yourself to go back and reread those articles to ensure that they do no contain information that may be relevant.

The above is a very brief introduction to some basic concepts in behavioural finance. What is most important to take away from this article is that everybody from the most novice investor through to the world’s most successful financial managers are affected by the same set of cognitive limitations. Without being aware of these and having strategies in place to actively counter them, you will significantly limit your trading potential. The intent of all my articles is to provide information to the crypto community that I feel may currently be lacking or not easily accessible. Should there be further interest in this topic then I will produce additional posts in the future.

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