Hopium isn’t free! Cognitive biases in crypto. Must read (long I know)

Cognitive biases are short cuts our minds take or tricks they play that cause irrational behavior and that is more likely to end in a bad decision. Usually we aren’t aware we have taken a shortcut. The interesting thing is that they are quite predictable and repetitive from person to person in the same situation. Daniel Kahneman received a Nobel prize for work done with Amos Tversky on this.

I’ve experienced at least 4 powerful ones in my crypto journey.

-Optimism bias -Endowment effect -Sunk cost fallacy -Confirmation bias

These are all interesting in their own right.

1. Optimism bias is where we have an unduly positive view of our chance of success. I say hopium isn’t free, because it costs you the ability to logically evaluate arguments against your optimistic position. For example, in the fantastic book “thinking fast thinking slow” Kahneman describes optimism bias in small business start ups. The chance of a small business remaining viable after 12 months is apparently about 35%. When asked, most entrepreneurs rated their own chance of success as 70%.

The interesting thing is that this misplaced optimism is robust to strong counter arguments, including actually educating the entrepreneur that the average success rate is only 35%. When the proponents of the start up are informed that the average success rate is only 35%, and then they are asked again what they think their chance of success is now in light of that new information, it doesn’t budge- still 70%. They have been robbed of the ability accurately evaluate the situation and new information.

1. The Endowment effect is where you place especial value on something just because you own it.

Don’t make the mistake of treating crypto gains as play or pretend money. Gains are directly (of course considering taxes and fees) interchangeable with fiat. There is a cognitive bias to be aware of here.

If you are lucky enough to make $10000 crypto gains (lucky you) after taxes (yes cgt discounts after a year of ownership are an extra consideration), then it is logical to do with that $10000 worth of gains exactly the same as what you would do with a $10000 gift in fiat.

If you would put all of a $10000 gift straight into crypto, then keep all your gains in. If you would do something else with some of it, then do that.

It’s not play money. Don’t invest more than you can afford to loose applies to gains too, if or when the gains get large enough that you can’t “afford” to lose them either. I say “afford” because it means something different here- you can clearly afford to loose the money because you didn’t have that money before. Would you be kicking yourself though, if you came across that amount in fiat and then lost it? Then maybe you can’t afford to lose it.

The cognitive bias here drives a tendency to illogical behavior where a person does something different with something they own that is directly interchangeable with fiat to what they would do with the same amount in actual fiat.

Asking yourself “what would I do with the same amount in fiat?” is a useful tool. Unfortunately you can’t necessarily trust your mind to give an honest answer, that’s how cognitive biases work.

This doesn’t actually only apply to gains, it applies to your investment if at break-even or a loss. If the external situation has changed and now you would do something different with same amount in fiat as what you would with what your investment is currently worth, then it is logical to do that. This leads us into the sunk cost fallacy.

1. The sunk cost fallacy

We talk about “you never lose until you sell”, but as crypto is directly exchangeable for fiat (yes fees) it really is one and same. $50 lost value in you investment is the same as 50$ lost. The fact you have already lost money does not effect what you should do with the remaining cash value of your investment. (The market trend that caused that loss might and probably should inform a decision though, as that is new information you didn’t have before.) If after losing $5000 dollars, you still have an investment worth $10000, then you should do what you would do at this moment and knowing what you do know with that $10000 if it were a cash gift. Again if that’s put it all in crypto then great leave it all in. If that’s something else with some of it then do that.

Learning from the past is useful and important and should change our future decisions. Money or value lost though, is lost and shouldn’t come into decision making.

1. Confirmation bias is straightforward but particularly relevant to Reddit due to the upvote mechanism. Basically the more you hear an argument the more likely you are to believe that it is true. This also robs you of the ability to properly evaluate other arguments. In Reddit, bear arguments are typically downvoted and bull posts are upvoted irrespective of quality of content. As a result you are much more likely to come across bullish content even if the number and or quality of bearish posts is high and so you are more likely to feel that the bullish sentiment is true.

Combine these effects together and our poor brains have a fair bit against them when it comes to making sensible decisions. My thought is that this makes it very difficult for many people to spot a bear market and also contributes a whole lot to a “hold or even buy when it is sensible to sell” mentality.

To finish up, cognitive biases are real and powerful and I think interesting. How they play out in crypto is open to question though. My interpretation may not be correct. Either way, I think it is worth knowing that your mind can’t always be trusted to think things through properly and the ways it makes mistakes can be repetitive from person to person and you don’t get any warning when it’s made one.

Ps. my first post since I had enough Karma to post here. Thanks to anyone who could be bothered reading to the end.

(Edited loose to lose- oops. No good at that.)