Why cognitive biases matter in investing and how to overcome them

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It wasn’t so long ago when the cryptocurrency market was seen as obscure and dubious due to the largely anonymous nature of its participants. Slowly but surely, institutions have begun to understand blockchain technology’s power to improve the global financial system. 

El Salvador even recently became the first country in the world to make Bitcoin legal tender, as trust in sovereign currencies like the U.S. dollar erodes. 

The high levels of volatility in the cryptocurrency market have also attracted a lot of speculators. Retail investors have flocked in looking to become the next crypto millionaires. Still, many have come to realize such gains cannot be achieved overnight, with the dynamics amongst traders in the crypto market similar to those in traditional markets — the vast majority of active investors underperform a passive, buy-and-hold strategy. 

New terms have gained popularity among cryptocurrency enthusiasts to highlight the importance of holding digital assets for extended periods rather than buying and selling. For instance, HODLers refer to investors that “hold on for dear life,” while diamond hands allude to investors who refrain from selling despite downturns or losses. 

Becoming a HODLer isn’t necessarily easy because many psychological barriers can cloud effective decision-making. Cognitive biases limit the ability to understand the direction of a trend. Consequently, many fall prey to exiting trades too early, hanging on to losing trades or deviating from well-considered trading plans.

Traders can avoid biases from ruining their success by understanding more about them, with the goal of learning how to overcome them:

  1. Anchoring bias occurs when investors rely too heavily on the first piece of information they absorb about a given topic. Instead of quantifying new information objectively, traders tend to refer to the point of their anchor as the starting point for their reasoning. Analyzing new data and coming up with reasons why the anchor is no longer valid can help overcome this bias. 
  2. Recency bias involves investors putting too much emphasis on new information without considering the reliability of the data over the long run. Traders overreact, making poor decisions as they overestimate the importance of a new data point — failing to recognise that single data points can be fraught with volatility and are best viewed in the context of the larger dataset. The best way to combat this bias is to have an investment strategy based on longer term trends, and stick with it. 
  3. Loss aversion is a bias that results from the human tendency for losses to elicit a stronger emotional response than an equivalent gain. Such discomfort can induce risk-taking behavior such as holding on to a losing trade too long with the hope of the market turning. This often results in realizing even larger losses later down the line. Accepting that even the best traders are right little more than 50% of the time, and implementing a solid risk management strategy can help overcome this bias. 
  4. Bandwagon bias results when investors follow the herd or do what most people do, disregarding personal beliefs. Often traders FOMO or panic sell a cryptocurrency based on crowd behavior. The key to overcoming this bias is to have a clear framework with which to analyze investments through — only following the crowd if the investment makes sense within this framework. 
  5. Confirmation bias manifests in investors taking on as valid information that aligns with an existing point of view, disregarding as dubious any conflicting data. Traders tend to dismiss any new data that proves them wrong, sticking to existing beliefs instead. Looking for facts that oppose one’s opinion, and reasoning clearly about why they are valid or not is one of the best ways to overcome this bias.  

Active traders usually fail to understand that these natural instincts can prevent them from becoming profitable. A widely known statistic says that 90% of traders are not successful: 80% lose money; 10% usually break even; only 10% percent can expect to generate returns from the price action in the markets. 

Just being aware of the biases at play may not be sufficient for many to be able to overcome the powerful emotional responses that the gyrations in the markets induce.  For this reason, cryptocurrency enthusiasts — particularly those without the time to actively research the markets — are beginning to shift towards passive investment strategies, such as Invictus Captial’s C20 or C10 funds, to avoid the pitfalls of cognitive biases.

Disclaimer. This is a sponsored post. Cryptopolitan does not endorse and is not responsible for or liable for any content, accuracy, quality, advertising, products or other materials on this page. Readers should do their own research before taking any actions related to the company. Cryptopolitan is not responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any content, goods or services mentioned in this sponsored post.

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