This article applies behavioural finance thinking to cryptocurrencies and highlights known biases exhibited by cryptocurrency investors. It then talks about the changing trend among investors, who are now focusing more on the technology powering cryptocurrencies rather than the currencies themselves. We then conclude with some tips on what to look out for as a professional in this sector.
Behavioural finance, biases and trends
Traditional finance and economic theory talk to us about the Rational Economic Man (R.E.M.), who bases decision making on the ‘expected utility’ of a decision and its expected outcome.
In order to define what expected utility is (refer to illustration #1), we have to assume that every outcome has a defined (or estimated) ‘financial gain equivalent’ or ‘financial loss equivalent’ and that each of these outcomes are associated with a well-defined (or estimated) probability, in advance. The theorem further assumes that for most individuals the increase in financial gain equivalents produces diminishing marginal returns.[i]
Illustration 1 — Expected Utility based on probabilities and pay-out
Note: The chart below shows utility generated from purchasing an item AND playing 2 lotteries with different possible outcomes and attached probabilities of those outcomes.
· Lottery 1: get $1500 with probability 1– this gives an expected utility of 2
· Lottery 2: get $5000 with probability of 0.4, otherwise you get $200 — this gives an expected utility of (0.4*3 + 0.6*1 = 1.8). Although the expected amount of money is greater from lottery 2 the utility is lower (0.4*5000 + 0.6*200 = $2120>$1500)
However, professionals in finance know that most of the time the ‘expected utility’ metric used by the Rational Economic Man (R.E.M.), is just an estimate and the probability we assign to each outcome can be swayed due to various biases inherent in human beings. These biases are normally categorized as cognitive errors or emotional biases. Either of these can require an adjustment to moderate a biased individual’s decision-making or to adapt to its, from a risk/return perspective.
Illustration 2 — Prospect theory-based on the framing of gains/losses
Also, within traditional finance is the ‘prospect theory’ (refer to illustration #2), which talks about gains or losses rather than final states of wealth, this has been widely seen and used strategically in the world of cryptocurrencies. It also indicates that most investors get a lower utility from gains and stand to lose greater utility from losses, of identical size. The speculators in the crypto space have been falling victim to their own greed and have been re-framing gains or losses with a promise of different final states of wealth with undefined time horizons, urging investors to stay invested as a show of ‘loyalty to crypto’.
This practice called ‘HODL’ is what leads to magnifying biases such as loss aversion bias, social proof bias and regret aversion bias in the cryptocurrency markets. In English, it means that we don’t want to realize a loss by closing a position underwater, go against our peers even if they might be wrong or face the possibility of missing an upswing. Eventually, these biased individuals are forced to realise bigger losses because of the so-called loyalty to ‘decentralisation’, cryptocurrencies and the community behind it.
From a banker’s perspective, cryptocurrencies have been viewed as a threat or the majority of them fail to understand the technology and therefore fail to embrace it, although this trend is now changing, we are still far from mass adoption. Because let’s face it, if you have a pre-authorised deposit set up, you reduce the need for a cashier at the bank. The same logic applies to various job functions of a banker. Businesses can end up reducing human error by using technology, but this also reduces the need for the number of humans employed.
The bankers who believed that self-driving cars would eliminate the need for drivers are having a difficult time digesting that they are on the same chopping block, due to automation using Artificial Intelligence, Machine Learning and Distributed Ledger Technology. The reduction in the number of jobs may not be at the same level for now, but it is inevitable in the long run. This is why limit orders exist in trading and portfolio management, anyone that believes that limit orders and trading software have not reduced the need for the overall number of brokers that work on a trading floor is essentially ignoring the truth. Automation in trading allows for better decision making without being error-prone to human cognitive or emotional biases, thereby, reducing the need for the total number of brokers needed.
In cryptocurrencies, these biases can be further alleviated due to the higher volatility and lack of understanding around the technology, industry, application, abstract regulation and malicious intentions of shady individuals targeting human greed. At the same time, despite having lived through an abundance of getting rich quick schemes in the form of pump and dumps and the prevalence of corrupt groups trying to evade taxes or launder illegal money, we have failed to adjust our expectations and approach. In addition, there are disagreements around the intrinsic value of cryptocurrency networks as many people question the value of these digital assets, which only make the waters murkier. Due to these issues, the adoption of cryptocurrency, blockchain and D.L.T. has suffered as the world rapidly saw the rise and fall of cryptos in 2017–2018.[ii]
Since then, a lot has changed in the world of blockchain and cryptocurrencies. We have been force-fed articles on the blockchain, cryptocurrencies and the economy of tomorrow. Meanwhile, the big consulting firms, banks and other key economy driving institutions have started to see the potential of blockchain and Distributed Ledger technology, which powers cryptocurrency networks. This has led to renewed and increased interest in, understanding and innovating in this space, as those that are still left in blockchain/D.L.T. have come together to redefine the industry in a better light. These professionals who come from varying backgrounds such as law, banking, health care, logistics and transport see the potential in the technology to change our existing systems for a better tomorrow. Especially when considering disruptive technologies as a stack, the combination of machine learning, natural language processing and artificial intelligence solidified by the trusted bond of blockchain and enhanced with the ability to automate simple ‘if-this-then-that’ functions, using smart contracts.[iii]
Why should anyone care?
So, what does this mean for the world of cryptocurrencies and blockchain? It means that we need to refocus our efforts into educating people around the biases they can potentially have and how to spot and correct for them. We also need to educate them on the usefulness of the technology, so that investment in D.L.T./blockchain can continue to move away from get-rich-quick schemes into technological progress for human-kind. At the same time, the industry needs to promote best practices, self-regulation, ethical standards and awareness.
The days of the HODL phenomena are gone and investors are waking up to the fact that blockchain will NOT solve all problems. For cryptocurrencies, this has become even more obvious. The infamous WhatsApp, Reddit and telegram groups are dying and the individual ‘ICO advisor’ who suddenly went from any random profession to ‘blockchain growth expert’ is also being questioned. We live in interesting times where you need to proactively be on the lookout. The only way to fight human greed, that leads to illegal and grey area activity at various ranks in institutions, is by promoting transparency and fixing areas that pose the biggest threat for society and individuals who lack expertise in this area. Therefore, it is important to be aware of human biases, how companies and individuals may try to exploit them and be ‘in the know’ with latest industry trends and regulations, to ensure we can make better and educated decisions when it comes to investing money into new technology.
[i] (Nell, E.J., 1975. Rational economic man. Cambridge University Press)
[ii](Barnes, P., 2018. Cryptocurrency and its susceptibility to speculative bubbles, manipulation, scams and fraud)
[iii](Nguyen, Q.K. and Dang, Q.V., 2018, November. Blockchain Technology for the Advancement of the Future. In 2018 4th International Conference on Green Technology and Sustainable Development (GTSD) (pp. 483–486). IEEE)