Why do we make so many terrible decisions?
Despite a good education, I’m not too proud to admit that I bought crypto at its peak in 2017, losing half of what I invested shortly afterwards by panicking and selling.
Many of us repeated this pattern all over again in 2022.
I’ve also made plenty of other bad decisions – including biking down a hill, in the rain with heavy traffic. To make terrible decisions through overconfidence is to be human after all.
However, when it comes to investments – we want to avoid the common pitfalls of our human behavior. To save on processing power, the brain uses shortcuts called heuristics. Using “a rule of thumb” helps us make quick decisions but it also hampers our reasoning.
Many of these cognitive biases or fallacies also affect our financial behaviors.
Our brains are fantastic at saving energy. That’s why those shortcuts, like suppressing visual input, not ‘hearing’ your partner speak, or forgetting that page you just read, are used. It’s why we have trouble accurately processing information.
We have to work hard to break these “time saving” habits.
Even the savviest among us will overestimate the probability of events occurring or fall for these biases.
Understanding these biases and implementing simple rules to improve our decision making will keep your wallet feeling fuller. Ironically we’ll be trying to outsmart our brain’s usual problem-solving abilities.
Common Biases and Where to Look for Them
Behavioral finance is the term for how psychological influence can affect monetary decisions. For example, we make poorer decisions if we invest when we are panicking. I have bought too much chocolate when I was hungry. Just once though. A few more situations that might affect our investor psychology in the stock market or crypto market, are below.
Our evaluation of a financial asset is heavily influenced by previous information. According to the anchoring bias, the first information you hear is weighed more heavily in any future evaluations. It doesn’t matter how accurate that information might be – it may still seep into your reasoning.
Let’s imagine you stumble upon a new cryptocurrency. You search through Discord, Reddit, and Google for information about this enigmatic new crypto. Perhaps the current price is set at $0.05 per token. You discover a discussion forum where everyone is talking up the value of the asset. Digging into one person’s detailed posts, you find that they believe it will eventually be valued at $5 per token.
Since this is the first salient information you’ve read about this crypto, it will influence your future decisions. It may even help you become overconfident. When you start thinking about whether it is overvalued or not, your brain will still have the price point anchored close to $5 per token. That is why you want to avoid mental accounting.
Sunk Cost Fallacy
Have you sat inside a movie theater, regretting your decision to watch a particular movie? Perhaps you decided to watch Cats (2020) completely sober. In most cases, people tend to sit through terrible movies because they feel like they paid for it. Might as well get the most out of it right? Wrong!
This is a classic example of the Sunk-Cost Fallacy. We put our money towards a movie (Cats) and want to make sure it’s spent well. Pretend instead of cats, you invested in volatile crypto instead. The price has dropped more than 1000% in the last few weeks.
When we think about recouping our losses and selling, we feel a pang of guilt. We are hard-wired towards loss-aversion, just like wall street, and selling this crypto would make these losses more tangible. We experience this effect because the psychological feeling of losing anything is more intense than any happiness we might gain from winning.
Sometimes as an investor, in mutual funds or crypto, you need to decide whether to salvage the $50 left from your $500 investment or let it continue to dwindle. Trust us, you’ll probably get a lot more out of those $50 if you sell the asset and put it towards anything more promising.
We all like to read things that confirm our views and beliefs. After all, anyone who thinks that a hotdog is a type of sandwich has to be wrong. Any evidence that they present for their position is either ignored and filtered out. Over and over again, we will seek the warmth of the echo chamber and the pleasant comfort of confirmation bias.
Assets on the blockchain are often supported by communities across the internet. Within each community, some believe that their favorite cryptos or etfs can do no wrong. In Discord or Telegram channels, any discussion or reasonable critique will be shut down or labeled as a comment spreading fear, uncertainty, and doubt (FUD).
It is important that individual investors like us always seek out multiple sources of reliable information before making financial or investment decisions related to crypto. Due to the community aspect, it is easy to fall into confirmation bias. I mean, you wouldn’t buy a car or house without first knowing and accepting any defects or issues with it.
Motivating Uncertainty Effect
With thousands of different cryptocurrencies, it’s hard to find a diamond in the rough. Out of these more than ten thousand cryptocurrencies, only a small portion of them will grow significantly in value. That means that you could buy thousands or even millions of a low-priced cryptocurrency and get rich if it’s adopted by more users. Or you could just put your money into something safe like Bitcoin or Ethereum, and reap steady gains.
Due to the Motivating Uncertainty Effect, we are attracted to risky investments. Even though there’s less than a one in a thousand chance of huge gains, we take the odds instead of steady moderate growth from proven assets like Bitcoin or Ethereum. At the back of our minds, we keep thinking that maybe we’ll get lucky and make 10,000% gains in a few years instead of a solid 10-20%.
The most important lessons grad students learn early on: don’t go grocery shopping when you’re hungry. This vociferous appetite will ensure you overload on way too much food and go outside of your budget. If we’re sad after a breakup, we’re significantly more likely to buy a gallon of ice cream.
Similarly, when it comes to cryptocurrency, our mood will seep into decision-making. If your current mental state is very happy and upbeat, you might overvalue a crypto asset. Similarly, if you’re sad or angry, these feelings could also influence the way you look at crypto-assets. If you’re feeling as volatile as Bitcoin, it is best to wait another day before making your investment decision. In psychology, this effect is called the Affect Heuristic.
Make Better Financial Decisions
Luckily, learning to invest smarter isn’t rocket science (it’s just economics, psychology, and traditional finance strategies). Savvy investors are well aware of these biases, especially the ones that they’re guilty of. Knowing that you’re not always going to be right, or make good decisions is a great first start.
Another way to counteract these biases is to actively look for information that combats your confirmation bias. If you regularly invest in Ethereum or Bitcoin, make an active effort to understand the critics and the possibility of volatility. Often, even great assets have their downsides — learning about them will help guide your investment strategy.
Smart Financial Planning
If you have a sum of money that you want to invest in an asset, it is much better to divide it up into weekly or monthly instalments. Rather than hoping you’ll find the best price when you buy in bulk, you’ll get a great deal by regularly buying that cryptocurrency. This strategy is called dollar-cost averaging, and a key aspect of wealth management.
Also quite important, budget out how much money you’d like to invest every single month. Make investment goals ahead of time, schedule weekly or biweekly buys of certain cryptos, and stick to the plan. This will take away the influence of psychological biases and fallacies that might make you want to invest a lot of money into a volatile asset at once.
Similarly, it is smart to have exit plans in place, especially in case of a bear market or downturn. At what point will you want to sell some of the cryptocurrency? For example, you might determine that once you get a 30% yield in a bull market, you’ll sell some of the cryptocurrency. Alternatively, if the price drops 70% and stays there for several weeks, you can have a plan in place to liquidate that asset. Oh and make sure to sleep on any large or major financial decisions.
Note: if you want to do more reading on this psychology, Warren Buffett, Benjamin Graham, and Daniel Kahneman are good places to start.
To save on processing power, our brain uses a variety of different shortcuts and rules.
However, when it comes to the complex modern world, many of these short-term decisions lead to poor decision-making.
No one is immune to poor cognitive reasoning, biases, or fallacies – after all, we’re all human here. These very same biases that might make us say or believe something irrational also influence our financial behaviours.
Briefly, some of these cognitive biases and fallacies include:
- Anchoring Bias: The first piece of information we hear about a crypto asset will weigh heavily on our future perception of it.
- Sunk Cost Fallacy: Know when to call it quits. Some financial losses aren’t going to be fully recoverable – cash out the remaining assets before they lose even more value.
- Confirmation Bias: We are wired to seek information that we agree with. In crypto assets, it is easy to fall down a confirmation bias rabbit hole. Always look for the critiques and weaknesses of any assets you’re interested in. Even Superman had a weakness.
- Motivating Uncertainty Effect: When we have the option of a known safe investment and something highly volatile with a small chance of +10000% growth, we are drawn to the uncertain asset.
- Affect Heuristic: Your daily mood can affect your evaluation of different crypto assets.
The best way to combat these biases and fallacies involves rational decision in financial planning.
Think like an economist. Decide ahead of time your allocation strategy, and split it up over weekly or monthly instalments. Lean into diversification.
Sticking to your plan and using Dollar-Cost Averaging will help ensure that you experience less risk buying and selling crypto assets.
With a solid plan, these biases and fallacies can no longer control your impulses and potentially hurt your wallet.