By knowing the key psychological traps, which are relevant for both beginners and experienced traders, crypto market players can save money (and nerves) as well as make more profitable decisions by anticipating the outcome of certain events. We examined what cognitive biases affect the behavior of crypto traders and the crypto market in general.
Data analyst Kyle Protho conducted a detailed analysis of the crypto market, identifying eight key areas where traders allow cognitive distortions in thinking. Cognitive distortions or errors are systematic mistakes in thinking or in perceiving the choices made. For example, there are often cases in trading when the principles of the same "successful pattern" overlap any market situation.
Most often, cognitive distortion occurs when:
Players in the market must make decisions under the condition of an excess of information from various sources.
The market situation does not reflect the real causes of what is happening, making it difficult to make a measured decision.
The decision must be made as soon as possible.
The trader does not have enough experience to make the right decision in such a situation.
If a trader encounters at least one of the conditions described above, then their decisions may lose the basis of their former rationality. The chaotic and relatively new nature of the crypto market, the growing number of ICO campaigns, and the increase in the number of media covering the news of the crypto industry all lead to the fact that players often make decisions in the presence of all these factors. Therefore, to make informed and rational decisions regarding further actions, traders should be aware of the key psychological effects that affect trading.
The Availability Heuristic
The availability heuristic refer to a process in which a trader assesses a situation depending on how easily such situations are presented or pop up in memory. As a result, the trader simplifies the event to simple judgments based on their own memories, which makes such an assessment biased. Thus, many new investors believe that the rates of altcoins will grow with the growth of Bitcoin. But the relationship between the profitability of investments in altcoins in comparison with Bitcoin is not always a fail-safe rule. The growth of the Bitcoin rate cannot be a guarantee that all other cryptocurrencies will grow without exception.
The Anchoring Bias
Anchoring or focalism is that in the process of assessing the situation, especially when it comes to numerical values, traders "anchor" their opinion to some estimates that were obtained earlier. For example, if a trader saw a high rating of an ICO project on some platform, then convincing them of the opposite will be several times more difficult than someone who does not know such ratings. In many cases, even the highest ICO rating does not guarantee the success of the project, and sometimes it can be simply purchased.
The Confirmation Bias
The propensity to confirm one's point of view is the tendency of the trader to seek, interpret, or give preference to the information that corresponds to their point of view, beliefs, or hypotheses. So, investors tend to encircle and limit themselves only with information that would confirm their own views. These prejudices make it impossible for investors to make an objective assessment of the market reality and do not allow them to take into account all the important aspects of the current situation. Moreover, investors will be more inclined to invest in projects, whose goals correspond to their own convictions and turn a blind eye to certain negative aspects.
The Gambler's Fallacy
The gambler's fallacy is often faced in gambling, sports, business, and even everyday life. This effect reflects a widespread misunderstanding of the randomness of events. According to the gambler's fallacy, people will unjustifiably overestimate the probabilities of random events that have not taken place in a long time, and which, in their opinion, are about to occur. For example, in the case of coin tossing, a situation may very well occur that 9 "heads" will fall out in a row. For many people, it seems obvious that the next roll will be the "tails." Such a conclusion, however, is erroneous as the probability of "tails" or "heads" falling is still 50%. The same goes for cryptocurrency, where there can be no guaranteed result, and any event bears a probabilistic character.
The Overconfidence Bias
With this cognitive distortion, the subjective confidence of the trader in the fidelity of their judgments is much higher than their objective accuracy. The most likely reappraisal will occur when performing intensive tasks, considering difficult issues when the possibility of failure is high, or when the trader, while assessing the chances of success, is not familiar with the problem or does not have the required qualifications.
The Effect of Risk Perception
The effect of risk perception is observed in conditions of uncertainty when decision-making is associated with risk and the possibility of an unfavorable outcome. In such situations, the trader's personal qualities will play an important role as well as how they cope with the problematic situation. If a trader voluntarily sets themselves similar goals and makes decisions to achieve them, then their risk appetite increases. They consider the risk justified and even necessary. Such traders, however, often remain in the red.
Illusion of Control
This cognitive distortion is expressed in the tendency of investors to believe that they can somehow influence the events taking place in the market, which objectively do not depend on them or depend to a much lesser degree. This effect leads to confidence that the investor is really able to take responsibility for what is happening, even if the events are spontaneous.
The Optimism Bias
People tend to believe that a positive outcome of a situation is more likely than a negative outcome. Thus, the trader has mechanisms of psychological self-defense from traumatic and emotionally negative information. Investors are inclined to believe that the invested funds will make a profit, even if they are invested in shitcoins.
These examples of cognitive delusions are quite common among crypto traders; however, this is not a complete list of possible psychological traps that investors may encounter.
According to Kyle Protho, the first step that will help avoid irrational judgments and estimates when investing in cryptocurrencies is to study and analyze one's own decision-making process. The second is a thorough investigation of the cryptocurrency, the team, and the project in which the investment is planned. Also, if possible, one should try to avoid making rash and hasty decisions.