What Are Behavioral Biases and How Can We Avoid Them?
TL;DR
Behavioral biases are irrational beliefs that can influence our crypto trading decisions without our knowing. Common behaviors that can influence decisions include overconfidence, buying or selling at the wrong time to avoid regret, limited attention span, and trend-chasing. Traders and investors should be aware of such biases and avoid them to lower the risk of making illogical decisions. Here are four biases and how to tackle them.
Introduction
Behavioral biases, when left unchecked, can lead to poor crypto trading and investing decisions. In fact, there is an entire field of study called behavioral finance, which combines psychological theory with conventional financial economics. Biases are often unconscious, so you must pay close attention to your behavior to reduce bias-charged decision-making.
Human behavior and psychology has been extensively studied by Israeli-American psychologist and economist Daniel Kahneman and the late Israeli cognitive and mathematical psychologist Amos Tversky.
Overconfidence
“The illusion that we understand the past fosters overconfidence in our ability to predict the future.”― Daniel Kahneman
The overconfidence bias applies to traders who are too sure of their trading ability, causing them to make risky market decisions or overly frequent trades. Traders may also be overconfident in assets in which they are already heavily invested, resulting in a portfolio that lacks diversification.
While there may be exceptions, a study led by Columbia University professor Dr. Kai Ruggeri concluded that the more active a retail investor is, the less money they make. Consider trading less and investing more, as investing often entails more fundamental research into the intrinsic value of a project or cryptocurrency.
You can also consider diversifying your trades after doing proper research. This can help you to reduce the overall risk associated with holding a single token.
Avoiding Regret
A study published in the Journal of Economic Theory by Jie Qin, an economics professor at Ritsumeikan University, showed that traders were twice as likely to sell a profitable position too early and a losing position too late to avoid the regret of losing gains or capital. We are hardwired to avoid remorse, even if that leads us to make illogical moves.
To curb the urge to do so, you can stick to specific trading and investing strategies instead of making decisions during market fluctuations. A simple approach to this is to automate your trades with pre-determined conditions, such as price and quantity.
One such strategy is dollar cost averaging (DCA), a practice traders use to invest fixed amounts at regular intervals, regardless of the asset’s price.
You can also use a trailing stop order, which allows you to place a pre-set order at a specific percentage away from the market price. Apart from automatically tracking price direction, trailing stop orders can help to lock in profit while limiting loss, ultimately helping you to avoid mistiming the market due to regret.
Limited Attention Span
Given the variety of tokens on the market, there are countless crypto opportunities available. However, we only have a limited amount of attention to spare to properly understand each option before trading.
Furthermore, there is often a lot of market noise surrounding different crypto opportunities. This could lead to trading decisions being made with incorrect or insufficient information.
Don’t rush into any trade you have not first examined closely. Instead of spreading yourself too thin, do your own research (DYOR) and conduct proper fundamental and technical analyses before trading.
In addition, it’s best not to rely on information from third-party influencers whose content revolves around potential crypto trading opportunities.
Trend-Chasing
Another study, conducted by Tulane University professor Prem C. Jain and University of Rochester professor Joanna Shuang Wu, found that 39% of all new capital committed to mutual funds went into 10% of the previous year’s top-performing funds, which is telling of our tendency to chase trends. This can lead to hasty trading moves instead of logical decisions backed by ample research.
Due to the volatile nature of the crypto market, traders may be misled by a token’s exponential price increase and neglect studying the fundamentals that support this spike. Instead of jumping on the bandwagon, consider assets trading below what you feel is their intrinsic value and not just focus on tokens that have performed spectacularly well.
Like Warren Buffet once said, “Be fearful when others are greedy, and greedy when others are fearful.”
Closing Thoughts
As humans, it’s natural to want to lean on our instincts when making decisions. Monitor your behavior and strive to keep your behavioral biases in check and you’ll be less likely to make poor trading decisions.