JULY 9, 2021
How our psychology impacts our investing
Many of us have experienced losses in our crypto portfolios due to bad investing decisions. In this article, we will take a closer look at psychological biases to help you understand how investments are emotionally and psychologically driven, plus guide you on how to manage your investment portfolio successfully.
What is investing psychology?
Psychology is defined as the study of the mind and it explores how it might affect our behaviour. Rather than understanding how investing is linked with rational thinking, investing psychology puts the spotlight on the cognitive and emotional behaviour of investors.
What role does psychology play in our investing?
While most people assume that we make decisions based on facts, in reality most of our decisions are based on cognitive and emotional biases. In other words, we are not as rational as we might think.
What are cognitive biases?
Cognitive biases refer to certain decision processes that are based on behavioural patterns that might not always hold up to rational thinking. On the positive side, these cognitive biases push us to make decisions relatively quickly, but on the downside, they can lead to flawed decisions.
The following chart of the SwissBorg token might look familiar to you, because you might have experienced similar feelings when it entered bullish or bearish momentum.
This chart illustrates how we make trading decisions based on our emotions, rather than logical reasoning. If you can relate to this emotional roller coaster, then you know first-hand that we don’t always invest based on logical reasoning, and the volatile world of crypto offers plenty of opportunities for emotional investing.
Fortunately, this decision-making psychology has been well studied, with several common behavioural biases having been defined. Being aware of these biases, and understanding how investment psychology works, can help us avoid these investing behaviours and make smarter, more successful, decisions in the long term.
Thus, we will cover some psychological biases and understand how they are related to decision making processes in crypto investing.
What are common psychological biases in crypto investing?
Some of the most common psychological biases in crypto investing include confirmation bias, overconfidence bias, irrational exuberance and loss aversion.
Confirmation bias describes the tendency to seek out confirmation rather than disconfirmation to strengthen our beliefs. So if you believe that chocolate is healthy, you might focus on the high antioxidant levels of raw cacao, rather than looking at the level of sugar in your favourite bar.
Generally, we want to believe we are right, and our mind looks for evidence to prove that we are. Because of this, we give information that confirms our beliefs more weight than information that is not in line with our values.
Where this psychological bias becomes problematic is when it encourages us to stick with an unhealthy or incorrect belief. In investing, confirmation bias could cause us to stay in a bad investment, because we will only consider evidence that affirms we made the right choice.
Let’s consider a bull-market scenario. According to confirmation bias, the brain will filter out information that carries bad news, as we will only focus on sources that confirm that we are indeed in a bull market.
For example, people who invested in Dogecoin believe that it will continue to perform well just because it mooned. However, many don’t acknowledge that there are no fundamental values behind the token because they will only support the belief that this investment will make them rich.
For every decision that will affect our investing portfolio, it is worth seeking out confirmation as well as disconfirmation from our perspective to make the best possible choice.
This psychological bias describes overconfident investors who believe that they know more than they actually do. This creates an illusion of control and knowledge where they think they are above average and know more than experts or other traders. In fact, they tend to ignore contradicting information as soon as they make up their mind about a topic. This behaviour leads to them overestimating their own abilities when forecasting the performance of their investment portfolio because they underestimate risks and think they are in control of how the market behaves.
But how is overconfidence bias related to investment decision making? When we feel overconfident and think we know best, we may be less cautious in our decisions and this will have a negative impact on our investments. For example, overconfident investors tend to be more active traders, because they are confident in their skills to enter or exit an investment at the perfect time. However, taking uncalculated risks or trading too frequently may not be the best strategy if you are not well-informed.
Let’s imagine an investor has successfully bought the dip and sold at a higher price several times, which will boost confidence in their ability to trade well. This confidence might grow to the extent that the investor thinks this strategy will work every time, regardless of market indicators. Overconfident investors might also think that a trading strategy that worked for one crypto is applicable to other cryptocurrencies, without being informed about each token’s fundamentals.
Irrational exuberance is related to the factor of overconfidence because it supports the belief that the market will behave in the future exactly as it did in the past. Such certainty is problematic because it is difficult, if not impossible, to predict how cryptocurrencies will evolve based on past trends. There will surely always be bearish and bullish trends in the crypto market and experts will confirm that price patterns can repeat themselves, but nobody can predict the future with certainty.
One of the problems with this mindset is the scenario where latecomers invest during a bull run phase that is followed by a correction. For example, investing in Bitcoin near the all-time high in April 2021 would have been a costly mistake at the time of writing, since it crashed in May with a loss of half its value. (Note that this isn’t a comment on the long-term trajectory of Bitcoin, but many short-term traders found themselves at a loss.)
This scenario is also referred to as a bubble where buyers are investing solely because they are experiencing the fear of missing out (FOMO). Since cryptocurrencies are gaining value, they feel it would be stupid not to join the trend, as they would be missing out on exciting opportunities. Irrational exuberance is a common bias in bull runs, because people would assume they will never end.
The concept of loss aversion refers to the preference of avoiding losses over acquiring gains. The key idea is that we react differently to loss and gain. The pain of losing is experienced as being twice as powerful as the pleasure from a similar gain.
The issue with this bias is that the fear of losing our investment prevents us from gaining returns with well-calculated risks, simply because we don’t want to incur losses in the process. Thus, loss aversion can have a negative impact, leading to impulsive decisions driven by our emotions. For example, the psychological impact will be much higher with a loss of $1,000 than with a gain of $1,000. If you have lived through days where the losses were particularly high and thus tremendously painful, then you know how strongly this psychological bias can be felt.
Let’s imagine we are in a scenario in which the market has not been performing well in the last couple of days. Here, the psychological bias of loss aversion will push you to sell to avoid further losses instead of taking advantage of low prices by buying more and growing your investment. The pressure of selling cryptocurrencies may come from the massive spreading of FUD (fear, uncertainty and doubt) on social media, leading to a movement of panic and irrational behaviour. But selling to avoid more losses also comes with a cost. At some point in time, the trend can reverse, which means you have missed out on the opportunity to acquire more gains.
Loss aversion is an example of how we make irrational choices based on the fear of losing. Being aware of this psychological bias will help us make more profitable decisions that go hand-in-hand with long-term investing.
How to avoid common mistakes investors make and improve your investing psychology
Now that we’ve covered how investing psychology works, let’s look at some strategic approaches we can implement to make better decisions in the long run.
- Before making investment decisions, weigh the pros and cons to choose the right combination of risk and return. If you think about your investment for a longer period of time, the short-term volatility of cryptocurrencies will have less of an impact on your investing decisions, as you can see how short-term volatility can turn into a trend over time. Being able to ignore short term ups and downs will make you more rational in your decisions about when to buy or sell, rather than making these decisions based on emotion.
- A common mistake investors make is that they buy at a high price due to social pressures (like FOMO) and sell at a lower price because they are experiencing loss aversion after seeing prices drop. The ideal approach in investing is to do the opposite: buy low and sell high. But with price fluctuations in the crypto market, this might be hard to implement. That’s why you might consider the approach of dollar cost averaging, which involves investing a specific amount on a regular basis. This means that you will grow your portfolio over time, rather than worrying about short-term volatility.
- Rather than following financial trends, focus on investments where you believe in their fundamental value. Taking a step back to evaluate critically whether you can see an investment growing in value over the long term will help you realise whether your investment is nothing more than a popular short-term trend.
Consider your investment goals before making any decisions. Your goals will vary according to whether you are planning to invest in an asset for the long-term (meaning, several years) or in the short-term (anywhere from a few days to months). If you are struggling with the cognitive biases listed in this article, a longer-term focus is generally healthier, as you are focused on the fundamental values mentioned in the previous point, rather than getting caught up in short-term FUD or FOMO.
- Challenge your point of view by being informed about different opinions and ideas will ensure you make well-informed investing decisions. You can look for YouTube channels and financial publications to help you in your decisions. If you have friends and family members who are successful investors, it might also be a good idea to ask them what they think about your investing decisions.
We have seen that investing psychology can influence our investing decisions negatively. The main take-home messages are:
- Always try to think rationally and take the time to consider different points of view for an investing decision.
- Investing for a longer period of time carries a less important emotional load, since short-term ups and downs won’t affect our portfolio that much. The SwissBorg app is a good way to manage your investments for the long-term and control your crypto wealth.
Now that you are aware of investing psychology, are you ready to start investing?
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