It seems like everyone and their grandmother is trading cryptocurrency these days. This is great because widespread adoption is necessary for crypto to reach its full potential. But these new traders are also at high risk of losing money for several reasons. First, each trade has a winner and a loser, and beginners are likely to come up short a lot when pitted against the more experienced traders, financial institutions, and algorithms with whom they're trading. Second, there is so much shilling and pumping and dumping in this effectively unregulated market that it is easy as a new trader to be convinced to buy a crappy token and have it plummet afterward. Finally, there are certain cognitive biases (i.e., systematic irrationalities in human decision-making and judgment) that predispose you to make suboptimal irrational decisions while trading cryptocurrency. This article will explain three of these cognitive biases so that you can be aware of them and, at the end, it will recommend an investment strategy for new (and, frankly, old) cryptocurrency investors to minimize the impact of cognitive biases on your trading.
Cognitive biases predispose crypto traders to make suboptimal investing decisions.
Loss aversion predisposes crypto traders who have experienced losses to sell or double down when they shouldn't.
Loss aversion is the phenomenon that people are much more motivated to avoid or mitigate losses than they are to seek gains. Losses are disproportionately painful to us and we're predisposed to take actions, even risky ones, to mitigate them. A related phenomenon is the sunk cost fallacy, which is our tendency to throw good money after bad in hopes of making up for money we already lost - e.g., doubling down when we should cut our losses. This is probably the most important phenomenon to understand because crypto is a very volatile investment, so it is very likely at some point you will see that your investment is crashing. I have been in crypto for several years and I watched my crypto lose 50-90% (depending on the token) of their all-time highs in late 2017. Having sold all my Bitcoin at $20,000 in December 2017, I thereafter bought it back at around $12,000 and held it in the red for most of the next three years in the red (going as low as $3,000), but I didn't sell. In fact, I bought more in the range of $5,000 to $10,000. Now a Bitcoin is worth $60,000.
The first time you see a massive crash in your crypto holdings, you will be tempted to sell because loss aversion. But the only time you actually realize your losses is when you sell - and guess who is buying up your holdings when you panic sell? Financial institutions and experienced traders, generally. They know the price will likely eventually bounce back. If you are invested in solid tokens (see below for a list), you generally should resist the impulse to sell unless you really need the cash, with the only caveat being if there is some big event that has a high likelihood of making your crypto valueless - e.g., regulators have made crypto illegal (very unlikely at this point in my opinion). I believe the chance of such event is low and hence the general advice is to just hold (or, as the crypto insiders say, just hodl). As a side note, one way that I mitigate the impact of crypto volatility is putting my crypto onto DeFi platforms that earn you a return that can mitigate losses, or amplify gains, in the crypto's value. Here's an article about how to earn an extra return on your Ethereum on DeFi platforms, and more articles on how to earn on your crypto on DeFi will be coming. Further, this post addresses why DeFi platforms earn you extra return on your crypto if you're wondering. Put your holdings on DeFi platforms, or put them in cold storage, and then stop constantly checking price (but do keep up with the market to make sure nothing catastrophic is happening). The added benefit of the just hodl philosophy is that every time you transact, there are fees, which eat into your profits.
Just hodl your crypto.
The other thing that can happen as a result of loss aversion is the investment version of doubling down. Suppose you determine that you can spare 5% of your liquid assets to invest in crypto and then you experience a large loss. That loss is painful and you want to do something now to fix it. You may be tempted to invest more. I mean, if you put more money in at this new lower price, you're lowering your basis, right? But, on the other hand, you are now putting in more assets than you originally decided was safe. And, if you experience further losses, are you then going to put in even more? Researchers have actually run hypothetical tests of this strategy where you essentially double down every time you lose money and shown that you will eventually blow up your account. I myself have done this in the BTC futures market??. The other point to note is that it is very important to make sure from the beginning that you don't invest more than you really can afford. If you invest more than you can really afford and then experience losses, you are going to be much more impacted by loss aversion and likely to make suboptimal decisions than if you just invest what you can really afford. Also, again, you can place your tokens on DeFi platforms to earn additional returns - this is a better strategy to dampen losses than investing more money.
The Dunning-Kruger effect, which is the phenomenon of beginners of an activity overestimating their ability at that activity, results in new traders being overconfident in their ability to trade successfully.
The Dunning-Kruger effect, named for the researchers who originally identified it, is the tendency of novices to an activity to overestimate their ability and knowledge with respect to such activity. In contrast, experts at an activity tend to not overestimate their ability and knowledge with respect to such activity. At first glance, this phenomenon seems strange - overconfident beginners and doubtful experts?? But have you heard the phrase "you don't know what you don't know". In other words, the reason beginners tend to overestimate their abilities and knowledge is because they have so little experience that they are not aware of everything that they don't know or cannot do with respect to the activity in question. The experts, on the other hand, have plenty of experience and knowledge to draw on and are able to more accurately assess their own skills and knowledge.
When you are a beginning or intermediate crypto trader (frankly, even an advanced retail trader), you may watch a few videos and read a few articles feel like you're ready to dive into trading. Because you haven't spent thousands of hours learning about cryptocurrency and trading, you don't know what you don't know about trading and cryptocurrency. You can see why this is a dangerous spot to be in - you are less likely to second guess your choices and probably make a big mistake that a more experienced trader wouldn't make. One thing you can do to counteract this to some extent is to start learning about cryptocurrency. But I still recommend the investment strategy I lay out below as the best way to counteract the impact of potential cognitive biases as much as possible.
The overconfidence bias leads new crypto traders to overestimate their chances of success.
This cognitive bias overlaps with the prior one except that it generally applies to people regardless of whether they are beginners. Most people overestimate their own skills and abilities and underestimate those of other people. Multiple studies have demonstrated this. Have you ever heard that 95% of people believe they ae above average drivers or 80% of people believe they are above average intelligence? To bring this point home, consider whether, when you started college, you thought you would be in the bottom half of the class. Probably no one did. But half of the people were in the bottom half. Researchers theorize that the overconfidence bias exists to basically keep us more content by protecting our egos. (Interestingly, a number of cognitive biases derive from ego protection or ego threat - e.g., people often hold onto an opinion even in the face of overwhelming evidence they are wrong because their ego becomes associated with their belief and it is ego-threatening to consider that they may be wrong.) The overconfidence bias is what led thousands of newbies to dive into ICOs (ie., initial coin offerings - a method of raising money for a crypto project through the issuance of tokens - unfortunately many of them were just overhyped scams) or buying up crappy tokens in 2017, and many of them got severely burned. If you aren't an advanced trader and your brain is telling you that you will be successful in trading and won't suffer much loss, that is the overconfidence bias at work. Remember how I also mentioned that the overconfidence bias includes underestimating the abilities of others? Also, recall that many other traders in this market are either very experienced or they are financial institutions or algorithms, all of which are likely better at trading than you. Were you remembering that when you overconfidently assessed your own chances of making money? If a friend told you they were jumping into trading in a market full of sophisticated financial institutions and algos, wouldn't you be worried they might lose money?
The good news, though, is that there still is a way to invest in crypto if you are a newbie that will limit the impact of cognitive biases, which I detail below. It involves very little active trading and relies on buying solid assets and holding them for a long time through thick and thin. I have a strong belief that crypto, especially DeFi, will change the world and I believe that the value of crypto as a whole will continue to go up in the long-term. If you feel the same, then all you need to do is buy some solid tokens and then hold onto them. There is no need to trade in and out of various sketchy tokens as crypto influencers and people on social media seem to constantly suggest. Below I provide more detail about this strategy as well as a list of what I consider solid coins.
Here are the steps of a crypto investing strategy that will limit the impact of cognitive biases.
So now you know, if you are not advanced as to cryptocurrency and trading, that you are subject to all these cognitive biases that may cause you to do poorly trading in the market, so what should you do if you still want to get into cryptocurrency? Here is what I would suggest and I can tell you that it is battle-tested because I have been investing in this market for a long time. This is specifically designed to minimize the impact of cognitive biases. I am not saying that this is the be-all and end-all strategy for every new crypto investor, but I would highly recommend this as a starting point for 99% of new investors.
Determine how much to invest.
- This should be an amount you are 100% able to lose. Don't do something crazy like getting a home equity loan. Even if you don't have any cash to spare now, you could start putting aside a small amount of your paycheck (have it direct deposited into a separate account) until you have maybe $500 or $1,000.
Allocate your capital among various tokens, beginning with Bitcoin and Ethereum.
- Next, I suggest you allocate some capital to Bitcoin, some to Ethereum, and, if you have sufficient capital, some to solid altcoins. If you don't have much (say a couple thousand or less) stick with just BTC and ETH for now. If you save up more you can expand into altcoins. I believe that every crypto investor should have some BTC and some ETH as a starting point. Altcoins are, admittedly, where you have the chance to have crazy high returns, but it is also where you can lose your shirt. Some people would debate this advice and say that it depends on your risk tolerance and investment horizon, but I still think every portfolio should have BTC and ETH. BTC and ETH are also readily available, so it is easier for a new investor.
- You're probably wondering how much is "some" capital to Bitcoin and some to Ethereum. I would do a rough split between them but with a larger percentage in ETH for two reasons. First, ETH is the primary coin of DeFi, and I believe DeFi is a revolutionary force that will eventually revolutionize our financial system. Second, I believe ETH has more growth potential, particularly because several upgrades are planned to the Ethereum network this year to make it more secure and scalable which should increase ETH's value. Bitcoin is only a store of value while ETH is
Select solid altcoins to purchase if you have additional capital to allocate.
- Here is a quick non-exhaustive list of tokens that I believe are solid. If a token is not on here, it is not necessarily bad. (I also cannot guarantee that every token on here is a good investment.) But you will need to diligence it thoroughly. I plan to write an article about how to do that, but if you are not comfortable doing that, I would recommend sticking to the first six altcoins on this list. Obviously I consider BTC and ETH solid as well but they are not on this list since they are covered in the step above.
- UNI
- YFI
- LINK
- MKR
- SNX
- COMP
- AAVE
- SUSHI
- SGT
- UMA
- BADGER
- EGLD
- DOT
- SNOW
- ATOM
- BAT
- ALGO
- AVAX
- ALCX
- REN
- BNT
- 1INCH
- NANO
- BAL
- CRV
Hodl (or put your tokens on DeFi platforms to earn additional return). Don't trade constantly - too many fees. You are not a freaking actively-managed hedge fund. Most of all, don't panic sell. Only sell to take profits or because you need the money. Don't constantly check prices.
This is the most important part of all of this because it is designed to limit the chances for your cognitive biases to interfere with your trading decisions resulting in a bad investment decision. Acquiring a mix of Bitcoin, Ethereum, and some solid altcoins and hodling them is a good approach for beginning and intermediate traders because it limits the numbers of decisions that you're making, which limits the number of times you can make a bad decision. Of course there are people out there who try to tell new traders that they should use technical analysis and try to make short-term profits, but for most non-advanced traders, I think that is a fool's errand - the fees will eat you alive even if you make good trades, but in all likelihood as a beginner or intermediate trader you are going to frequently be on the wrong end of trades. If you are constantly watching the charts to try to identify good entry and exit points, you will be constantly seeing the value of your investments go up and down, which, due to the cognitive biases discussed in this article,
Be very wary of shilling. If you stick to solid coins, you don't need to worry about getting taken for a ride. If you want to venture into the equivalent of penny-stock crypto, learn how to do deep diligence.
Crypto is full of shills. Honestly it drives me crazy. They are not too hard to spot but what they say can be very tempting. There must be some cognitive biases that make us gullible towards shills because people fall for shilling a lot. But in most cases shills are just trying to pump their own bags. Be especially careful around crypto influencers. A lot of them buy a coin, recommend it on their blog or YouTube channel, which pumps it, following which the influencer dumps their bags, and then the token dumps to its proper price, leaving viewers with a big loss. Crypto is really the wild wild west in many ways - pretty much unregulated. Discord and Telegram channels organize crypto pump and dumps of crappy useless coins. That people are easily swayed by shills is yet another reason to stick to a strategy like the one I outlined above (or another strategy that does not involve actively trading and buying shitcoins).
If you invest in a smart reasoned way, you have a good chance of preserving and growing your savings.
Many people are getting into trading cryptocurrency (or, more alarmingly, buying NFTs speculatively - check out this post on the basics of NFTs).
Cognitive biases can lead people to make poor investment decisions.
About the Author: Harvard grad and former corporate lawyer is passionate about Ethereum and DeFi and has been investing in and using crypto for many years. She was inspired to write this blog covering the basics of DeFi, liquidity mining, farming, and tips and tricks and mistakes to avoid for DeFi newbies, as well as other Ethereum-related topics, to increase the number of people using ETH and DeFi by making it more accessible. Follow my blog on this platform for more posts on these topics. Thanks for reading!
