Crypto & The Cognitive Biases That Drive Us

Fear and greed are strong emotions in cryptocurrency and those that can control these emotions separates the pro traders from the worst. Cognitive biases are at the core of every decision we make as traders - Identifying & understanding that these biases are at times completely irrational will enhance your trading performance ten-fold.

Cognitive Biases - What are they?

There are several cognitive biases that traders should be aware of. But in this blog, I want to focus on 4 of the most important biases that, in my opinion, have the biggest impact on a trader's ability to make sound judgment calls.

Anchoring bias

“...there was a common cry calling for a euphoric 'blow off the top' moment because this is what happened in every historic bull cycle.”

An 'anchoring bias' is when traders rely heavily on what happened in the past in order to make predictions for the future. For example, during the last bear cycle, the Total Market Capitalization declined by -x% so during this bear market we will also see -x% - this is what happened in the past so this is what will happen now.

During the last crypto bull run of 2020/21, there was a common cry calling for a euphoric 'blow off the top' moment because this is what happened in every historic bull cycle. Even when the raw data presented suggested otherwise, many traders bought into the idea, got lost in the moment, and unfortunately became 'top buyers'.

Many trading ideas are based on historical data, previous macro patterns, and past cycles. However, having an 'anchoring bias' means that one might be biased toward casting aside new information or possible changes in market structure and cannot see the relevance. As a result, a trader with an anchoring bias could be stuck in a 'mental comfort zone' and rely purely on old and potentially irrelevant data.

If you rely purely on historical context and ignore new information then you could be setting yourself up for an undesirable result in your trades. Always evolve your trading ideas/plans to incorporate not just past data, trends, and patterns but also current information too.

Confirmation bias

“We often try to seek out information that confirms our bias to give us confidence in our trades.”

Confirmation bias is very common amongst cryptocurrency and forex traders. We often try to seek out information that confirms our bias to give us confidence in our trades. We will often completely ignore relevant information that can challenge our bias - "I don't want to read this, I must have conviction in my trade!"

In doing so, you risk ignoring important market information that challenges your idea, possibly even dismissing warning signs that your decision might be completely wrong.

This can create an infinite loop of misinformation, likely resulting in wasted time on Twitter searching for Tweets, or Googling articles with the sole purpose of reaffirming your bias just to strengthen your conviction. 'Confirmation bias' needs to be understood and nullified in order to construct a robust trading strategy. Traders must absorb all the relevant information they can in order to make rational decisions - if a trading idea sounds too good to be true, try to identify the holes in it and potential risks no one else is considering rather than look to reinforce it.

Overconfidence bias

“Traders would do well to never let 'hubris' dominate their trading strategies - there is no substitute for sound planning...”

There are times in the market cycle when trading seems way too easy, you have entered the realm of 'trading ninja', you feel like you've mastered the art of trading and in no time at all your portfolio will be in 10s of millions... We've all been there at least once.

The only thing that is constant is change - This overconfidence can be detrimental to your trading strategy and the ability to adapt to a changing market structure. If a trader believes that they can not lose due to their impenetrable trading strategy then sound 'risk management' often takes a backseat and trading strategy and overall focus can get very sloppy. There is definitely nothing wrong with building self-belief in your trading skills, but be aware of the danger that too much self-assurance can negatively affect your trading decisions.

An overconfident trader can become arrogant. They start to neglect the charts and even the advice of seasoned professionals. Traders would do well to never let 'hubris' dominate their trading strategies - there is no substitute for sound planning, and just because the previous trade went well never expect the next to be a foregone conclusion - success is always earnt, never a given. Every trade is different and the market structure is forever changing beneath your feet.

Loss aversion bias

“trading strategies become more risk-averse as traders seek to protect capital and minimize loss...”

In contrast to the 'overconfidence' bias, we also have the opposite: 'loss aversion bias'. This bias is an affliction of the underconfident. Fear is at the heart of many bad trading decisions and plays a major role in this particular trading bias.

Sometimes traders find themselves in a rut, a string of losses, or sometimes the market has been in a downtrend for a significant period of time. This can lead to an irrational fear of losing one's capital. Therefore, trading strategies become more risk-averse as traders seek to protect capital and minimize loss.

There are times in the market cycle when taking vigilant care of your capital makes complete sense, at times of high volatility and extreme uncertainty for example. But, if you find yourself jumping in and out of trades due to fear of making yet 'another big mistake' then perhaps a 'loss aversion' bias is affecting your ability to judge accurately your entries and exits. Sometimes the best thing to do in these situations is to step back and take a break from it all and take a proverbial bath, rather than try to trade your way out of a losing streak.

A trader with a 'loss aversion' bias often closes a position much too early as they lack the confidence to let a good trade run its course, in fear of losing those profits. Likewise, the same trader finds it very hard to cut a losing trade, they cannot take the additional loss on top of the previous string of losses.

Final Thoughts

In the community trading rooms that I manage, I would seldom come across a trader that didn't suffer from at least one of these cognitive biases, if not all 4 of them. These are biases that we don't simply just overcome and forget, they need to be remembered and reinforced over time to ensure that they never creep back in to disrupt a robust trading strategy. Observing and appreciating that these biases exist, in all walks of life, and that they do have a major influence, will help to reduce the overall effects. This allows us to use rational, fact-based evidence, devoid of fear and greed, to enhance whatever it is that we are trying to achieve, in trading or otherwise.