Is cryptoing a rational activity?
Ideally, cryptoing, or trading in crypto currency, should be a rational and structured activity, but investors are often guided by their emotions rather than their rationale.
Let’s have a look at the most common investment biases as identified by several university researchers.
Behavioral finance is a whole new area of research that studies how investors repeatedly act irrationally under specific circumstances. Following are some of the most common biases: loss aversion, disposition effect/regret theory, mental accounting, herding, anchoring and representativeness bias.
Each of these are discussed in more detail below.
These risks are particularly relevant when investors make decisions alone in a fast-moving environment. It is specifically the case of most crypto retail investors. This irrationality clearly leads to poor investments and this is the reason why cryptoing generates losses rather than gains for most of people
Everyone is affected by these types of recurring mistakes in our logic. The only way to diminish their influence is to be knowledgeable about them and to act accordingly.
6 common cryptoing mistakes that make lose money
These are the riskiest types of irrational behavior that occur while cryptoing:
- Loss aversion. Losses are twice as painful as the joy of making gains according to Kahneman and Tversky in their research “Prospect Theory: An Analysis of Decision under Risk”. This leads to very conservative approaches even when the investment would be more profitable with a bit more risk.
- Disposition effect/Regret theory is the tendency to sell assets where investors have seen some gains. Likewise, to retain their losses regardless of the prospects of seeing a future reversal
- Mental accounting. Investors behave differently depending on how they have received their money. Namely, money gained without effort (e.g. a Lottery) will be spent quickly without a proper planning, while money from hard work will be spent cautiously
- Herding. People tend to copy the actions of their community. This behavior is particularly risky in finance as it amplifies the risks of bubbles and bear markets
- Researchers Tversky and Kahneman in 1974 describe Anchoring as the tendency to rely excessively on the first information that was available
- Investors also tend to make decisions by leveraging too heavily on their prior knowledge, focusing on the information that confirms their beliefs, while ignoring data that disproves it (Representativeness bias)
Irrationality leads the whole market
Cryptoing is not only risky for the volatility of assets, but also due to emotions that might lead investors to make poor decisions. The only way to minimize these types of cognitive biases is to develop a rational and structured approach to investing. Furthermore, collaborating with other people, especially financial experts, can lead to more rational decisions.
Recently millions of retail investors were harmed by their cryptoing activities as this market fell to about 1 trillion dollars from its peak of 2,9 trillion dollars (November 2021). This massive sellout is linked to some of those cognitive biases as investors sold their assets as everybody was doing it (herding) and they panicked as they were reading negative titles on news media (Anchoring).
In this context, the only way to minimize losses is to analyze the situation rationally avoiding any behavioral biases