Introduction

As cryptomarkets are growing and new participants join the markets on a daily basis, I thought it would be beneficial for some to understand some basics of behavioural finance. Although I am not an expert on this topic, I am a student of finance and I found this part of my lectures particularly interesting, so I'd like to share my knowledge with you ;)

For a very long time, all the finance theory was built upon the belief that markets are efficient and investors behave rationally. Based upon those beliefs, some of the most important and well known financial models and theories such as the Capital Asset Pricing Model and Markowitz' Portfolio Theory have emerged. In the more recent years though, opposing theories like Behavioural Finance have become more and more popular.

The reason why Behavioural Finance has gained more attention are several market anomalies. One of the more famous anomalies is the so called "January Effect". It has been observed that between 1904 and 1974, the average monthly return of small firms is comparatively high in January. This does not comply with the efficient market hypothesis, which states that stock returns follow a „random walk“. Some say the reason for the January effect are investors, selling their loser stocks in december to reduce their capital gains tax liability. However, the January effect also occurs in environments free from capital gains taxes. Other prominent anomalies include the „days of the week“- and „small-cap“- anomaly. Market anomalies like these are the reason, behavioural finance theory emerged. This is only to give you a small historic background.

Behavioural / psychological biases

There are quite a lot of psychological / behavioural influences on our investment behaviour. I will focus on those that are (in my opinion) the most relevant to us cryptoinvestors. This article features „anchoring“ and „overconfidence“.

Anchoring:
Example: Say you enter a price negotiation for a specific good, for example a car. The salesman tells you an initial price of 10,000 USD. Now this initial price acts as an anchor for the negotiation. You will of course try to negotiate a lower price and in fact any price below the anchor will seem a good deal to you, regardless of the true value oft he car.

For investors anchoring occurs most often in the form of absolute entry prices for which we have made our investment initially. Such an anchor can prevent you from making a correct decisions, e.g. sell an overvalued or buy an undervalued investment or it can cause you to disregard a false decision, e.g. hold on to a losing investment.

It is very hard to overcome anchoring because it happens subconsciously. However if you happen to realise that you are subject to anchoring, you can try to correct your view and distance yourself from the anchor. This could be done by revising a fundamental analysis of your investment or by listing arguments that challenge the anchor.

Overconfidence:
Psychology has found that people have a tendency to have causeless confidence in their abilities. We generally rate ourselves as being above average and overestimate our knowledge and capabilities relative to others. Overconfidence can lead to poor decision making. For example, investors sometimes put too much of their wealth in a single portfolio, because they are confident that they pick a winning investment, thereby significantly increasing risk. Studies have shown that picking winning investments, i.e. such that beat the market, is very hard to do, even for professional investors). The same overconfidence may also result in making too many trades, which may have a negative effect on your overall returns.

How to overcome? Overconfidence can be overcome by considering multiple opinions or approaches. In other words, include other people and sources in the process but at the same time make sure that your sources of information are reliable (don’t necessarily listen to the troll box on Poloniex ;)).

I hope you enjoyed this article. I will soon cover more behavioural finance.