top of page
  • Writer's pictureArka Roychowdhury

Behavioural Finance at play in Crypto

Updated: May 16, 2023

The world of finance has for quite some time accepted the idea that human beings rarely exhibit the decision making prowess of a rational economic man. Our common man (enslaved by social media and afflicted by cognitive and emotional biases) limits himself within the bounds of rationality, relying on heuristics and shortcuts to reach decisions that merely “satisfice”.

Limits and probabilities are not intuitive to our common man, mathematics manages to mislead him just as easily as it manages to give him clarity.

Lets look at Confirmation Bias:

Our man tends to selectively place more emphasis on the part of the information/content that aligns with his existing beliefs, and secretly undermines or ignores evidence that contradicts him.

He tends to pay attention to what confirms his beliefs more than what contradicts him. Social media algorithms make things worse by amplifying contents that validate his belief, and obscuring everything else that might not trigger an adequate dose of dopamine.

Algorithms that feed on our attention have no incentive to moderate our biases.

These algorithms are designed to show users content that aligns with their interests, preferences, and past behavior. As a result, users are more likely to be exposed to content that confirms their existing beliefs and values, and they may be less likely to encounter contrasting perspectives.

For instance if we keep watching videos (content) about the potential of crypto markets, and how doomed the dollar is and how flawed the central banking systems are, we are going to be fed more and more videos (content) that confirms that all we need is crypto to avoid an impending doom.

As he interacts more with content that confirms his existing beliefs and values, he is more likely to encounter similar content in the future, and consequently find himself trapped in a “filter bubble”.

With every scroll our crypto enthusiast is bombarded with confirmations from a thousand other content creators and rarely stumbles upon anything that might challenge his hypothesis, perpetuating the cycle of selective exposure

He soon finds himself in an echo chamber sequestered from any challenging view points.

This explains why someone who bought into the idea of crypto (or adamantly against it) rarely notices any red flags (that may seem obvious in hindsight).

Loss aversion: Unlike the rational economic man (risk averse), our common man or woman is loss averse. He feels much more strongly about his losses than about his gains. Consequently he goes a greater length to protect against losing what he has than he goes towards scouting new opportunities. Numerically equal expected losses and expected gains don’t have the same quantum of associated negative or positive emotions. Loss aversion may explain why a crypto speculator may continue to speculate even after losing significant wealth, as is it very distressing for him to not recover losses. He may hold on to a particular token that is losing in value (not sell), so that he doesn’t have to realize the loss.

Another pitfall that our common man, enthusiastic about crypto faces, is the base case neglect. He often over reacts to a news article or a tweet. For example he is tempted to invest all out in a particular NFT or a token (liquidating other more reliable assets) after a celebrity tweets about its upward trend or hears something positive about it from a guest speaker at a popular financial news channel- over-weighing the new information and under-weighing the base case.

He also falls prey to sample size neglect. For instance, immediately after hearing a YouTube influencer brag about his recent exploits by employing a particular strategy, our common man implements the same strategy- ignoring that he may not have validated a period of data long enough to suitably test the effectiveness of the strategy.

Gambler’s fallacy: It is a classic pitfall arising from our inability to grasp probabilities. A speculator, who has recently made successive bad bets, continues to bet believing that his luck will turn in the next bet. Let's say that he believes that the probability of any newly launched crypto to yield 3x return during his holding period is 30%. After investing (betting) and losing money in three consecutive crypto projects, he believes he is due for his return, ignoring the fact that the probability of success for each subsequent bet remains exactly the same (i.e 30%).

Prices of stocks or Crypto are indifferent to the anchor price that our common man has in mind. Anchoring bias occurs when the investor has a set price in mind (usually an arbitrary number that he encountered at the onset of his decision process), and he calculates his gains and losses based on this value. In a common marketing technique high-priced items are displayed alongside lower-priced items to make the lower-priced items seem like more of a bargain.

For example, an investor might have initially bought a cryptocurrency at a particular price point, and even if the market trends shift from that point, he might continue to hold onto it because he is anchored to that initial purchase price.

Our common man should strive to avoid such traps in the NFT marketplaces (in-game merchandise stores) and try to value an asset for what it is worth.

Endowment bias: individuals tend to value an asset or investment more highly simply because they own it. This leads to a reluctance to sell the asset, even if it is no longer performing as well as expected or there may be better investment opportunities available.

In a creator economy, an NFT brings a sense of ownership of the digital content. An asset that you own, and that is not replaceable by another identical one (e.g your wedding right is not the same as any other ring of the same price), triggers an endowment effect.

NFTs (Non-Fungible Tokens) can create a sense of endowment because they enable ownership and control of unique digital assets. This adds value to the asset, giving it a sense of uniqueness that cannot be duplicated. Endowment is not a bad feeling in itself, but excessive emotional attachment to an asset- a sense of pride and exclusivity in owning a part of something that others cannot have, can make it difficult for an investor to treat NFTs purely as an asset class.

Influencers overestimate their own abilities and knowledge, while potentially offering inaccurate information to their followers. This can be explained by a well known phenomena called the Dunning-Kruger effect. Confident sounding influencers who present themselves as experts or authority figures in crypto investing and like to talk about esoteric terms such as HODL or show you some trend charts, often lack the necessary expertise.

These influencers may not always have sinister intentions, but their actions can cause harm when they forget that their expertise lies solely in making quick entertaining contents/videos and not on the actual topic that they claim to be an expert on. We should be wary of unsolicited recommendations.

Rug-pull method, a very common form of crypto fraud, involves scammers creating hype around a crypto project- promoting it heavily with promises of high returns. Once enough people have invested in the crypto or the project, the scammers abruptly pull out all of their own investments, causing the value of the associated crypto asset to plummet. These scammers exploit the pressure (often unjustified) faced by investors and “wanna-be-millionaires” to jump on the bandwagon of a promising new cryptocurrency before it's too late (FOMO).

Mental shortcuts have their advantages too- if you see a large predator stalking you from a distance, you would be better off sprinting away at once, and not standing calmly calculating the actual risks and probabilities of getting gobbled up, or thinking about the different mental biases that could be affecting your instinct to run. In the modern world, rarely do we encounter a man-eating predator lurking in the corner. In this world our ability to think long term, and play multiple possible scenarios in our head before taking an action, helps us become successful. Instincts are important, but mental shortcuts shouldn't completely overrun critical reasoning. Attention demanding apps that are almost impossible to evade, can create a mire of an illusory world that doesn't really exist beyond the screen and the noise. Awareness of our biases and logical pitfalls can help in some way to protect us and our investments.


Recent Posts

See All

Before developing a GenAI Strategy

The advent of Artificial Intelligence (AI) marks a pivotal moment in history. BCG’s study revealed that consultants using AI completed 12.2% more tasks, 25.1% faster, and produced over 40% higher qual


bottom of page