Crypto Investing - Behavioral Pitfalls💱

In this article, let's talk about two fundamental concepts of investing related to human heuristics and capital market. This highly prevalent yet underappreciated topic of descriptive nature, has progressed greatly due to diligent study of Traditional Finance & Academia, whereby developed an entire theory called Behavioral Investing. This field is essentially broken own into two categories, which we will cover extensively in this article!

The failure of investors often relates to their personal heuristics, which translates into one (1) Investment Biases and (2) two less common but still very prevalent topic of portfolio managers incurring Cognitive Errors. Institutional investors, who tend to mostly use ‘indexed’ products in their portfolio construction process, favorably happen to avoid classic investor pitfalls of with active investing. However in more recent studies, have shown (reference needed) that when it comes to their rebalancing strategies, portfolio managers might error outright or cause a portfolio drag due to not properly evaluating their risk profile and parameters. 

Similarly, cryptocurrency markets are like these conventional capital markets, so lets dive in!

According to Charter Of Financial Analysts, The CFA ®, Behavioral Finance also argues that (not) all market participants act rationally with their investment decisions and especially not in their portfolio construction. If we extend this investment paradigm of behavioral investing to digital assets, Investment Biases proliferate cryptocurrency investing! What we could conclude, either flawed risk management practices, or behavioral finance errors have contributed to fall of some of the biggest entities in digital asset space, from Celsius Network, BlockFi, Genesis, Three Arrow Capital and most recently FTX Holdings Ltd. We can argue that a first wave of cryptocurrency bull market was was crushed by a lack of professional understanding of behavioral economics.

INVESTING BIASES - Investors, are most likely guided by their innate, ‘gut feelings’, that’s true with Behavioral Finance and Academia becoming a hot topic nowadays.

We will make our best effort here, to provide you with a full list of Investing Biases and we hope you will take a minute to read, contemplate and perhaps even evolution your portfolio construction process and or current allocation ! We will provide you a description of each bias, and hopefully add notes that can help our community, with definitions, cope with investing emotions better, preventing mistakes. This is a complete list of Behavioral Finance biases that investors may suffer 👇

📍 Overconfidence and Illusion of Control — bias attributes investment making decisions, to individuals ability to discern knowledge from a tendency to hold a false and misleading assessment of our skills, intellect, or talent.

📍 Self Attribution Bias — A self serving bias is a tendency in behavioral finance to attribute good outcomes to our skill and bad outcomes to sheer luck.

📍 Hindsight Bias — Hindsight bias is the misconception, after the fact, that one “always knew” that they were right. Someone may also mistakenly assume that they possessed special insight or talent in predicting an outcome.

📍 Confirmation Bias — Confirmation bias is the tendency of people to pay close attention to information that confirms their belief and ignore information that contradicts it.

📍 The Narrative Fallacy — One of the limits to our ability to evaluate information objectively is what’s called the narrative fallacy. We love stories and we let our preference for a good story cloud the facts and our ability to make rational decisions. This means that we may be drawn towards a less desirable outcome simply because it has a better story.

📍 Representative Bias — Representativeness heuristic bias occurs when the similarity of objects or events confuses people’s thinking regarding the probability of an outcome. People frequently make the mistake of believing that two similar things or events are more closely correlated than they actually are.

📍 Framing Bias — Framing bias occurs when people make a decision based on the way the information is presented, as opposed to just on the facts themselves. The same facts presented in two different ways can lead to people making different judgments or decisions.

📍 Anchoring Bias — Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. For example, if you first see a cryptocurrency that costs $1,200 per coin– then see a second one that costs $100 per coin — you’re prone to see the second one as cheap. Whereas, if you’d merely seen the second coin, priced at $100, you’d probably not view it as cheap.

📍 Loss Aversion — Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion. Often loss aversion shows that investors feel the pain of a loss from previous experiences more than twice as strongly as they feel the enjoyment of making a profit from current investment gains.

📍 Herding Mentality — herd mentality bias refers to investors’ tendency to follow and copy what other investors are doing, especially coins promoted by influencers. They are largely influenced by emotion and instinct, of being popular rather than by their own independent analysis and due diligence.

COGNITIVE ERRORS - Now can focus on Cognitive Errors, which is also a very prevalent topic in the cryptocurrency space, and is often associated with mistakes, or errors in processing information or judgement. Cognitive Errors can be classified into two categories: belief perseverance biases and information-processing biases.

📍 Belief Perseverance Error — Belief perseverance errors reflect an inclination to maintain one’s beliefs. The belief is maintained by committing statistical, information-processing, or memory errors. Belief perseverance biases are closely related to the psychological concept of cognitive dissonance.

📍 Information Processing Error— Information-processing biases result in information being processed and used illogically or irrationally. Often, information is not processed on time, or at certain times, not processed correctly.

Are we clear ? A recommended journal keeping — encourages investors to jod down or write their investment portfolio holdings on a paper and check (cross) your decisions according to each bias and cognitive error.

Now the biggest questions remains, could you have been influenced by your emotions ? Did you always act rationally ? We do not sound like a preacher to the coir that every single decision you make is possibly was clouded, but we hope you can begin to objectively reflect on your decision making process in the future and and study your own behavioral tendencies to improve performance. 

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