Behavioural Finance and Cryptocurrencies

Abstract

This paper analyses the rise in cryptocurrencies and the different behavioural heuristics that market participants experience. These include the hot hand and gambler's fallacy, the availability and illusion of control heuristic, social forces and FOMO. Cryptocurrencies are manipulated, high risk and speculative investments, an unregulated market filled with whales and many individual retail traders that are highly leveraged and emotional. Behavioural finance therefore helps us understand volatility and overreactions in cryptocurrency prices which is the aim of this paper. Also, for investors to recognise their own bad decisions and potentially capitalise on them in the future cryptocurrency bull run.

Introduction

In recent years, there has been a surge in the popularity of cryptocurrencies such as Bitcoin and Ethereum with thousands of new market participants joining every day. Despite warnings from the European Banking Authority (Hackethal et al, 2021) and massive volatility observed in the 2017 and 2021 bull run, retail investors will likely return. Understanding the behavioural characteristics of these investors and how emotions affect their financial decisions is critical for navigating the future cryptocurrency market. This is because they’re a major contributing factor to volatility and overreactions in price. Due to their anonymous nature, this remains relatively undocumented which is why this paper will refer to different behavioural heuristics, data on retail traders provided by professor Tobin Haspel and my own three-year experience as a cryptocurrency retail trader.

What is Behavioural Finance?

Behavioural finance is a field of study that explores how emotions, cognitive biases and other underlying psychological factors can influence financial decision-making. It looks beyond traditional economic theories that assume investors are rational and don't act on emotions. Retail traders that invest in cryptocurrencies appear to act very irrationally and base financial decisions on emotions such as regret and FOMO. Therefore, behavioural finance provides valuable insights into why people invest in cryptocurrencies. This paper will reference different cognitive biases and their impact on the market and participants, examples include the illusion of control, the gambler's and hot hand fallacy with each bias reinforcing the other.

Just like any other market, cryptocurrencies follow a very cyclical pattern dependent on underlying economic factors. In contrast to other markets, the cyclical nature of cryptocurrencies is more dependent on psychology. As shown in figure 1, market tops are reached when investors are at their max confidence and market bottoms when investors are experiencing despair. Large informed players (whales) want to buy at the lowest price and sell at the highest. As Investing/ trading is a financial transaction, a buyer and seller must be present. For whales to sell large volumes at the highest price, they need a large number of retail traders to buy off them. Fortunately for them, at market tops retail traders experience overconfidence, the illusion of control and many other cognitive biases. This combined with the FOMO experienced on social platforms and the media creates the perfect psychological environment for whales to sell and cause market tops.

What are Cryptocurrencies?

Bitcoin was invented in 2009 by an anonymous person or group called Satoshi Nakamoto to revolutionise the way people engage in financial transactions by not having to rely on banks or governments, thus reducing transaction costs (Nakamoto, 2008). Since then thousands of alternative (alt) coins have been developed using blockchain technology. Cryptocurrency is a very speculative and unregulated market that provides small retail investors with the opportunity to make life-changing money but also a market that has the power to bankrupt multi-billion dollar hedge funds such as 3 Arrow Capital. Mainly two types of investors navigate the cryptocurrency market: the informed institutional investor with larger amounts of capital and the uninformed retail trader with irrational and emotional heuristics, many of which don’t understand what they are buying and engage in high-risk investments.

Due to the lack of regulation, whales can manipulate cryptocurrencies by pushing the chosen coin to specific psychological prices to incentivise retail traders to enter trades. As these areas present large amounts of liquidity, whales can push the price back in the other direction to force liquidations amongst retail traders. In traditional markets, it is seen as a conflict of interest for an exchange and a market maker to be owned by the same entity. However, in the cryptocurrency market, there are many examples of exchanges such as FTX that also own a market maker (PYMNTS, 2022). The issue with this in an unregulated market is that the exchanges and market makers can collude to exploit traders. Manipulation in markets significantly increases volatility and therefore the emotions experienced by traders. Other examples of manipulation include; pump-and-dump schemes, whale wall spoofing and stop-hunting (Rahman, 2023).

An important topic in cryptocurrency is the frequent use of high leverage, not only among retail traders but large institutions. Leverage is a financial instrument that should only be used by advanced investors/ traders as it allows them to increase their position size whilst increasing risk. Particularly with cryptocurrencies, It is a major contributing factor to volatility, the frequency and size of crashes in price. The use of high leverage in a market intensifies all of the emotions investors experience as if they were on steroids, I remember the thrill and adrenaline from entering a 20x leverage trade. 3 Arrow Capital was a hedge fund in Singapore with the largest global cryptocurrency holdings, it was very overleveraged and went from $10 Billion to zero after failing to meet margin calls (Sigalos, 2022). This came as a shock to the market as it showed everyone that even at the top level, informed players struggle to regulate their emotions and avoid leverage. Due to the lack of regulation, retail traders have access to up to 100x leverage on certain exchanges which significantly increases the risk of a trade (Journal, 2023). In this case, liquidation will occur after the price moves 1% in the wrong direction which is arguably gambling.

Does trading Cryptocurrency have gambling characteristics?

Gambling and day trading both share many similarities as they’re both very high risk with 97% of day traders losing money (Gramalam, 2023) and 95% of gamblers losing money (Maremont, 2013). The majority of day trading occurs in a short time frame which means individuals have to rely on technical analysis rather than fundamental analysis. Although technical analysis can provide a proven edge in the market, it is normally misused by traders and gives them the illusion of control. Research by Arthur and Delfabbro showed that people who gamble are significantly more likely to engage in day trading (Arthur et al, 2016). The gambler’s fallacy is a belief that the probability of something happening becomes higher or lower as the process is repeated. It is also the belief that random events are linked and that each event influences another (Johnson & Tellis, 2005). An example would be betting red on a roulette table because it has landed on black the previous 7 spins and not recognising that the probability of landing on either colour remains the same regardless of the last spin.

In the cryptocurrency market, traders will experience continuous losses longing a downtrend in anticipation that it will eventually reverse. In this case, individuals will argue that the trend in price has to change the same way the colour of a roulette spin must change. This is why cryptocurrency traders experience the gambler's fallacy, resulting in volatility and traders losing money. Research conducted by Tobin Hanspal showed that cryptocurrency investors were “three times more likely to trade penny stocks, twice as likely to buy lottery style projects, with characteristics of low prices and high historical value of volatility, resembling gambling and trading for entertainment” (Hackethal et al, 2021). This is further evidence to suggest cryptocurrency traders have gambling attributes.

The Illusion of Control

Just like gambling, cryptocurrency trading isn't based solely on chance and there is an element of skill and strategy that can impact the outcome of a trade. However, cryptocurrency traders suffer from the illusion of control which gives them the belief that their skills or strategy have a larger impact on the outcome of the trade than it does. For example, a trader may buy an altcoin because there’s a falling wedge pattern breaking out on large volume whilst Bitcoin is also breaking out. The same thing has happened before (representative bias) and due to the illusion of control, the trader believes the breakout is certain. Elon Musk tweeting and causing the market to crash (Gandel, 2021) is a great example of a larger contributing factor to price than the individual's skill. The illusion of control is most likely bolstered by other heuristics such as the hot hand fallacy, social forces and FOMO.

The Hot Hand Fallacy

The hot hand fallacy is where individuals believe their previous success will lead to future success. In this case, traders believe their next trade will be successful if their previous ones were as well. It is particularly common in cryptocurrency due to the market's manipulative nature. As explained before, whales attempt to trap traders by pushing the price to psychological points. As price trends towards this point, retail traders enter several profitable trades giving them the belief that their analysis is correct. The trader is also likely to be overconfident and has the illusion of control, further enticing him to enter another trade. Eventually, whales change the trend and the trader is liquidated.

Regardless of manipulation, cryptocurrency investors will still experience the hot hand fallacy due to the high momentum and performance of cryptocurrencies. DeBondt and Thaler argued that “consumers who rely on past information become overly optimistic about past winners” (Johnson & Tellis, 2005). In other words, individuals believe their previous success will lead to future success. At the peak of the 2021 bull run, cryptocurrencies were increasing 50-300% in a single day and traders were experiencing large gains and FOMO. Due to the hot hand fallacy, many traders entered risky trades and lost money when the market went in the other direction. A great example is figure 2, which shows the cryptocurrency Matic increasing 246% in 5 days and then plummeting 72% within 5 days, quickly followed by a sharp rise.

The Availability Heuristic

This bias refers to the tendency of investors to overestimate the importance of information readily available from the media and social media hype, whilst underestimating the importance of not readily available information such as economic data (Lanoie, 2021). Cryptocurrency investors assume that if something is in the news or garnering buzz, it must be important. An example is the hype driven by Elon Musk and Dogecoin. Retail traders exclude the potential impact of sound economic data and don’t question the reliability of the information which leads to an overreaction in price and therefore volatility. This is how bubbles form and a prime example is Bitcoin at $69’000 in November 2021, economists were warning the world of a potential global recession whilst retail traders and the media were anticipating Bitcoin to reach $100’000 (Bambrough, 2022). Research conducted by Tobin Hanspal showed that cryptocurrency retail traders were drawn to projects mentioned in the media or amongst other investors further proving the availability heuristic (Hackethal et al, 2021).

Overconfidence amongst retail traders

Overconfidence occurs when individuals have an inflated sense of their abilities and a miscalibration in the accuracy of their knowledge, often leading to irrational financial decisions. This is very common in the cryptocurrency market due to the illusion of control, which gives traders the inflated sense that their technical analysis skills have a larger impact than it does. Their overconfidence causes them to enter more trades which can be proven through the research conducted by professor Tobin Hanspal. Data collected by “banks that offer retail clients in Europe and the USA an indirect avenue into cryptocurrency” showed that cryptocurrency participants trade 9-10 times a month in comparison to equity traders who only trade once or twice (Hackethal et al, 2021). This evidence could suggest that participants in the cryptocurrency market are more overconfident as they trade more.

Social Forces in the Cryptocurrency market

During the last bull run, social forces played a massive role as it led to the emergence of influencers, media hype and pump and dump schemes. I experienced the power of social forces through Elon Musk who had been posting cryptocurrency-related tweets causing large amounts of volatility in the market. He announced to his followers that Tesla cars will no longer be able to be bought with Bitcoin due to their negative impact on the environment (Gandel, 2021). From previous events, I knew this would have a significant impact on an already weak market so I sold and the market proceeded to crash 50-80% as shown in figure 3. This is a prime example of herd mentality and market sentiment in cryptocurrencies as investors sell together when they hear bad news or see the price dropping, consequently, we frequently see massive crashes of 40%+.

Many rational cryptocurrency influencers such as Coin Bureau focus mainly on fundamental analysis and economic data (Bureau). However, many ill-informed speculative influencers promote incorrect information and low market cap coins to their viewers. These individuals will show evidence of how much money they're making through watches/cars, and use clickbait titles and charts to show massive anticipated growth giving viewers a sense of urgency and FOMO. This can be shown in figure 4, showing a thumbnail for a youtube video from a well-known self-interested and ill-informed speculator called The Moon. This is another example of the availability heuristic and how retail traders make bad financial decisions from incorrect information.

FOMO

One of the strongest psychological factors that appear to influence cryptocurrency trading is FOMO which stands for fear of missing out. It refers to the anxiety and unease that investors and traders experience when seeing others make money. This gives them the feeling that they need to get involved in the action before it's too late. As cryptocurrencies are very volatile and can skyrocket at any point, investors act irrationally and make impulsive, risky decisions. Fomo is very common in the cryptocurrency market due to large price movements and social media platforms such as Telegram and Discord where groups for individual coins can be formed. Within these groups, individuals promote massive anticipated growth and cult culture which creates FOMO. From my experience, volatility and cult culture are the greatest contributors to FOMO. Research conducted by Tobin Haspal showed that cryptocurrency traders are “three times more likely than equity investors to chase trends and purchase assets with recent high performance and momentum” (Hackethal et al, 2021). This could be due to FOMO as investors don't want to miss the trend or large price movements.

Prospect Theory and The Disposition Effect

Prospect theory is a behavioural economics theory developed by Kahnemann and Tversky in an attempt to explain how individuals make decisions when faced with uncertainty (CFI,2023). It assumes losses and gains are valued differently by investors, placing more weight on perceived gains than losses. This is due to the loss aversion effect, a cognitive bias where investors experience losses asymmetrically more severely than equivalent gains (Liberto, 2022). In other words, the psychological pain of losing is stronger than the joy of winning. This overwhelming amount of fear can cause investors to act irrationally and make bad financial decisions. Prospect theory is an ideal candidate for explaining cryptocurrency price movements as the market is dominated by individual retail traders with little experience and also because the market is unpredictable due to high volatility. Research has shown that little trading knowledge is accompanied by a higher degree of loss aversion (Chen et al, 2022) and a “more inverse s shaped probability weightings” (Baars & Goedde‐Menke, 2021), both key components of prospect theory.

Prospect theory helps us explain the disposition effect, a well-known phenomenon that investors tend to sell winning investments too early and hold onto losers too long (Haryanto et al, 2019). It is not clear why this effect exists but it could be emotionally driven by regret and pride by not wanting to admit being in the wrong. This can be shown in figure 5 where realised losses are greater due to regret. The S shape curve shows how investors become risk averse after experiencing gains and risk seeking after experiencing losses which could also explain why investors hold losing investments and therefore the disposition effect. On the other hand, prospect theory suggests cryptocurrency traders should become more risk-averse after experiencing gains. This is not true as many experience the Illusion of control and the hot hand fallacy which increases risk-seeking behaviour, not reduces it.

Conclusion

Cryptocurrencies are very high-risk speculative investments that have become a fashionable trend to participate in. We are currently living in a generation where individuals want to make quick money overnight and get rich quick, so cryptocurrencies will likely carry on receiving mass media and retail attention. Retail traders are very emotional and make up a significant portion of the market, this combined with leverage and lack of regulation makes cryptocurrency extremely phycological. Understanding why retail traders make irrational decisions and the reasons behind them can help traders predict price movements. Therefore behavioural finance is critical for navigating the future cryptocurrency market. Many different heuristics affect decision-making, in particular the illusion of control, the hot hand fallacy and FOMO which is very powerful due to volatility and social media. The illusion of control is very common as many retail traders attempt to day trade using technical analysis and when combined with high amounts of leverage, it becomes gambling. Finally, the hot hand fallacy is a popular recurring theme due to the market's manipulative nature and the inability of humans to regulate their emotions after being successful. To conclude, understanding behavioural finance, different cognitive biases and their impact on decision-making is critical and arguably one of the biggest factors in cryptocurrency trading.

Figure 1

(Sebastian Sinclair, 2022)

Figure 2

Matic

Figure 3

Bitcoin

Figure 4

(Moon)

Figure 5

(Fairchild)

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