Chapter 6

Investing Psychology—the Right & Wrong

A young man walks into a casino determined to walk away rich. Walking into a VIP room, he talks to a wide swath of individuals, all of whom had “made it big” in the casino scene. They all point to the slot machines and say this was the best way to become rich. The man approaches the slots with confidence—an old man walks by just as he is about to play. “I’d think twice if I were you before you put everything you own into that machine.” The young man laughs and responds mockingly, “Don’t you know this is the best way to become rich? I’ve been informed by everyone in the VIP lounge this is the best kept secret.”

The young man put everything he owned into the slot machine.

The young man lost everything.

The young man learned a valuable lesson about survivorship bias.

Behavioral Finance

Investing psychology is an uphill battle. With investing, your mind is at war with some of the most basic human instincts. In an infinitely complex world, decision-makers need cognitive shortcuts. My main goal in this chapter is to tackle the fundamental investing psychology mistakes and make you aware of how easy it is to fall prey to these misjudgments. Hyperawareness of these foundational cognitive issues will make you a much more capable investor.

Meet Shawn Russell, a British property developer. He invested a little under $1,000 in early 2017. As 2017 progressed, he eventually invested $120,000 into cryptocurrency. In November 2017, his net position grew from $120,000 to $500,000. Shawn had little experience with financial products, and he had the perpetual belief the price was going to continue to go up. As the market plummeted in 2017, Shawn lost 96 percent of his overall net worth as he refused to sell while his net position dropped dramatically.

A variety of cognitive factors played into this situation. Why did Shawn not sell earlier when he was up? If you go from $500,000 to $200,000, you are still up $80,000 from your initial $120,000 investment. Why didn’t he sell and take a profit while he still had a chance? These the questions haunt so many investors that live through bubbles. Ultimately, this lack of logical decisions ties back to your cognitive biases, greed, and vulnerability to a range of quiet psychological quirks many investors are wholly unaware of.

The purpose of examining behavioral finance is not to give you the ability to beat the market. Hersh Shefrin, the author of the first-ever comprehensive piece of literature on behavioral finance, stated, “I think most investors are overconfident about their vulnerability to psychologically induced errors, and although intelligent, [they are] not as intelligent as they believe themselves to be.” The purpose of an investigation into behavioral finance is to help you avoid financial mistakes by spotting and avoiding dangerous cognitive shortcuts and biases attached to your investing tendencies.

Biases & Shortcuts

Cognitive biases are the ways we diverge from rationality within our judgement. To be irrational is, at the core, to believe in something that is not reasonable or logical. We have many cognitive weaknesses as well; certain scenarios (high risk and high pressure) are more likely to draw out irrationality. Recognizing which cognitive biases are consistently threatening us, as well as what scenarios bring out these biases, results in safer investing.

•Evaluation Bias of Conjunctive and Disjunctive Events

People tend to overestimate the probability of conjunctive events (e.g., all fifteen steps of my home-improvement project will happen without any hiccups). The more events that need to occur before a certain outcome, the less likely it is to occur. For example, in order for x price to occur, developers need to do A, B, C, D, and F. The more events needed for a fundamental price change to occur, the less likely it is to happen. And yet while this is intuitive, research has shown people don’t account for additional conjunctive events’ impact on the likelihood of the outcome.

The inverse of this rule is also true; people tend to underestimate the probability of disjunctive events (at least one part of my thesis will go horribly wrong, leading to a terrible sequence of all-nighters). Essentially, our brains often ignore worst-case scenarios. As a teenager, you might have heard of the Superman complex. Evaluation bias of disjunctive and conjunctive events is the adult version.

An illustration of this bias can be seen in the exuberance during a bull run. Oblivious investors ignore the possibility of bad news. Discounting the possibility of anything going wrong tends to result in investors being “surprised” when a negative piece of press makes its way online—resulting in a volatile price swing that hurts their overall position. Another case is an investor sinking cash in a new cryptocurrency based on the road map of development laid out by the developers. The investor’s conjunctive bias assumes everything will occur in succession with minimal hiccups, much to their chagrin when significant friction is encountered.

•Biases of Imaginability

Your memory is biased. You might not like it, and I don’t blame you. At the end of the day, your memory damages your investing judgement. Here is how: you under-rehearse unpleasant memories, leading to biased, availability-based inferences.

The inverse is also true. We over-rehearse pleasant memories.

This bias is represented by many investors during a long-drawn-out bear market—investors will make decisions as if at any moment there will be a replica of the last bull run. Another illustration takes place during a bull market after a long-drawn-out bear market. Because the investor has been “stung” so many times by the investment, when the price finally starts to trend upward, the investor is controlled by the euphoria of the price movement. This under-rehearsal of an unpleasant bear market corners the investor into throwing away the fundamentals as they simply choose to dangerously ride the price upward as an emotional decision as opposed to a logical one.

•Biases of Availability

People assess the frequency of a situation or the probability of an event by the ease with which instances or occurrences can be brought to mind. This is why being an experienced investor allows you to be more in tune with the ebbs and flows of the market. A drastic drop or pump in price for someone who has seen it happen hundreds of times is more likely to react in an unemotional strategic way compared to someone who has not been in the same situation as frequently. Journaling also helps reduce the impact of this bias.

•Insensitivity with regards to regression towards the mean

Extreme outliers tend to regress toward the mean in subsequent trials, and intuitively, we expect subsequent trials to be representative of the previous trial. As a result of this insensitivity, people fail to anticipate regression to the mean. This is apparent in how people expect the market to behave after/during an extreme bull or bear trend. Our minds don’t want to accept the highly probable event that the run was an outlier. You will see people claiming that the fundamental underlying value of said asset (during the run) has changed, when in truth the trend was a statistical outlier that has a high probability of returning to the mean at some point in the future.

•Insensitivity to Predictability

Predictions are often made by representativeness. In other words, if a cryptocurrency is described favorably (lots of incoming updates/upgrades) we predict outcomes that are similar (new investors and a higher price). What is not taken into account is the reliability of the information. This is a sobering insensitivity. We trust too quickly and expect too much. Unfortunately, your job as an investor is to make decisions based on information that is oftentimes incomplete. The best thing you can do is strive to obtain quality information to help battle the difficulty of making predictions with imperfect information.

•Insensitivity to Sample Size

Insensitivity to sample size in investing is a cognitive bias that occurs when people judge the probability of predicting an outcome without respect to the sample size. Variation is more likely in smaller time frames, but new investors are not necessarily cognizant of this. As a result, those with less time in the market have a smaller sample size and are often unaware of the bias they have toward short-term trends when first jumping into the investing game. This is detrimental to quality decision-making. Insensitivity to sample size is why new investors tend to act overconfident about their decisions.

My Data Insensitivity

In early 2018, this cognitive bias had a deep impact on me. As a first-time investor, I was checking the charts every couple of minutes. I would pull up my phone and watch the market move on a one-minute time scale. Because I had such little time in the market, I would go from having conviction everything was about to soar to, only a couple of hours later, believing the price was going to collapse permanently.

Glued to the chart, I was hyper-focused on every little trend change. My sample size was terribly small, and I had almost no long-term strategy to speak of. After many quick trades, I quickly realized I needed to learn to observe and invest in long-term trends using larger sample sizes other than just a week’s worth of data. While I feel somewhat embarrassed to reflect on what I looked like as an investor at the beginning, in hindsight it is apparent many biases were battling (and winning out) over me!

•Survivorship Bias

Dead men don’t tell tales. Neither do investors who lost big. People flock to successful investors, not accounting for the fact that their track record may be very short. In addition, people generally feel that everyone around them is making it big with investing. This is mainly because the majority of voices are those who are successful or claim to be successful. Be aware of this dynamic! Whether someone is selling you investment services or advice, think about the survivorship bias and how you might be jumping to an inaccurate conclusion as a result of an incomplete picture.

Journaling

Our brain fundamentally does not process with a consistent, logical approach. Be wary of your memories. This is why journaling your investment thoughts and decisions is so important. Journaling allows you to overcome memory discrepancies by giving you a snapshot of your mindset during all the turbulence of investing.

Christian Ryther, founder of Curreen Capital, is a strong believer in investment journals. He commented in early 2019, “I think investment journals are underestimated as a tool—a big part of the benefit comes from reducing errors and mistakes. As humans we don’t like to think about mistakes because it doesn’t fit the narrative our ego creates that tells us we are consistent and correct in our thoughts.” What does an investment journal look like?

An investment journal consists of the following entries:

•The date

•The asset

•Why you are invested

•How much you own

•Target sell price

•Target buy price

•News and developments

By updating this type of journal every seven days, you give yourself the opportunity to be able to view your emotional and cognitive fluctuations over the course of time relative to price movement, news, and fundamental changes. This type of journal is invaluable as you begin to understand your investing instincts. As Christian Ryther states, “Your job as an investor is to have an accurate view of reality and an accurate view of yourself to better understand how to make investment decisions with incomplete information. Investment journals give you clarity about a variety of risks, and answers questions that arise.” Learn to view yourself with a historical lens and you give yourself the chance to not fall prey to making uninformed, spur-of-the-moment investment decisions.

Cognitive Wolves

Let us now move on to the broader pastures of cognitive biases. The following make up the seven deadly cognitive wolves that are lethal to everyday investing sheep:

•Fear of Regret

•Overconfidence

•Anchoring

•Hedonic Editing

•House Money Effect

•Loss Aversion

•Winner-Loser Effect

Fear of Regret is the enemy of the everyday investor. It’s that moment when you check the charts to see how your investments are doing, read an article about an investment you don’t know, and as a result feel that “itch” to sell your current investment while simultaneously jumping ship to a new one. The problem with FOMO (Fear of Missing Out) is sometimes it does work. More likely than not, though, it is for all the wrong reasons. Decisions based on a feeling of fear and greed will slap you down more times than they will help.

A proverb I believe captures this fallacy is “Hasty climbers have sudden falls.” Making a series of hasty, fear-based decisions might work once, twice, or maybe even three times in a row. But all it takes is one of these emotional decisions to throw you off the proverbial cliff.

A huge chunk of your investment portfolio could disappear with one hasty decision, leading to a series of more fear-based investments to make up for the loss. I know countless stories of traders chasing gains after losses. But the truth is that you can drive forty miles to the nearest casino and the Fear of Regret is clearly evident. This is not solely an investment phenomenon. It dictates how we view gains in relation to risk. FOMO can only be mitigated with discipline and a plan.

As Publilius Syrus, a famous Latin writer from 85 BC, put it, “Anyone can hold the helm when the sea is calm.” Patience, strength, and discipline are the characteristics you must build up in order to be resolved enough to not act on FOMO when it attempts to throw you overboard.

For those invested in an asset that rapidly gains value, FOMO is easy to avoid because you are already riding a wave of success. And yet, as a bubble continues to develop for those riding the crest, FOMO begins to damage an investor with an amazing net positive position.

I have seen investors convinced an asset is going to go from $900 to $20,000 after the asset already saw an absurd 200 percent growth from $300 to $900 in a matter of months! These are the individuals that have made a once-in-a-lifetime investment, and yet the cognitive bias of FOMO still prowls around on these successful investors. FOMO preys on the greed and fear that believes the growth of an asset will continue, even if this type of asset price growth is logically unsustainable.

Overconfidence is a closely related cousin to FOMO. People tend to set overly narrow ranges of possibilities for price on medium time ranges, not accounting for huge swings downward or upward as a result of unforeseen events and market conditions. In other words, every investor has some small percentage of their mind that believes the lie that they can predict the future and the range the price will fall within.

In addition, people tend to believe the price of an asset can only drop so low when it starts to enter into its own bear market, often causing people to try to catch the “falling knife.” While people scoff at the idea of being someone who would try to grab on and play such a dangerous game, because people set overly narrow price ranges subconsciously, when the price falls past their subconsciously narrow price range, they will often say to themselves, “This is a steal of a deal. Surely it will not go lower. The bottom is in.” The market wolves love to pick off and devour overconfident investors. When you are working with your financial well-being and safety, there is no room for ego in decision-making.

This idea of narrow confidence bands and price prediction all tie back to anchoring. Anchoring is a psychological effect that causes people to consciously pick a price for what an asset will be one day valued as. This is not bad; models exist to do this for us. Here is the problem: anchoring, as a bias, chooses to ignore the effect of new information on the target price. This is illogical, but a consistent phenomenon across every level of financial prediction. How can anchoring be avoided?

You must be ready to readjust your predictions based on new fundamental improvements to a crypto asset or underlying blockchain protocol. This is why journaling is so imperative. If you find yourself having a static number that you are waiting for an asset to reach, and news comes out but you do not change this price point, stop yourself. Update your investment journal by accounting for the new information.

As a wise colleague of one of my university projects said, “Blessed are the flexible, for they will not be bent out of shape.” If you refuse to “flex” your target buy or sell price because of new information, then you are falling prey to price anchoring.

Hedonic Editing is a strange effect that stands alone in this pack of wolves. Hedonic Editing is the effect in which the frame and model with which you view a certain investing situation, and even the language involved, fundamentally alter the way you view a gain or a loss. An example of this is when professional investing consultants and asset managers use language concerning net positions. When talking about “closing an account,” people get extremely uncomfortable and unhappy with their investment decision. When the language is altered to “transferring an asset,” suddenly people are much more open and excited about what is to come, even if both sets of language describe a loss.

This effect comes into play with dividend-based stocks versus non-dividend-based stocks. A stock that is operating at a loss from the initial purchase price point without dividends will cause investors to feel a strong sense of loss. Add in a dividend, and suddenly the entire frame of mind people operate with is altered: “It’s okay, I am getting steady dividends from this, it will pay off in the long run.”

I suspect this exact effect will come into play once staking and dividends with cryptocurrency are fully implemented into blockchain protocols such as Ethereum. As of right now, the potential to be able to receive some sort of valuable dividend from owning a certain amount of a crypto asset is highly sought after and speculated over, far past the point of reason. The effect language has on our frame of mind cannot be underestimated. Where you get your information from is imperative to forming the lens with which you view the investing world. You must be careful with how you allocate weight and authority to the resources you read and consume relative to your crypto investments because of the danger of Hedonic Editing skewing your view of reality because of the language used.

One of my favorite effects to talk about is the House Money Effect because it has plagued my mindset as an investor ever since my first investment. It goes as follows: people who are “in the green” are more likely to take risks at a disproportionate rate than if they are not in the green. Say I give you a twenty-dollar bill. You are more likely to be willing to take a risk with that twenty dollars than if you started at zero dollars and had to pull out your own twenty-dollar bill. If your twenty dollars turns into forty, you are more likely to take a risk with that forty than if you had to start from scratch with a new twenty-dollar bill. This is perfectly illogical, and once again not surprising.

How much better would your investment decisions look if you never knew whether you were operating at a loss or a gain? If you were operating under the assumption you are breaking perfectly even, your decisions would look a whole lot more levelheaded and logical, as you wouldn’t know you were returning +56 percent or –32 percent on investment. The House Money Effect is merely a reflection of human greed and the ability to pull off mental gymnastics as justification for making continuous high-risk decisions in order to validate FOMO.

Loss aversion is typically the term the financial world gives to individuals who are low risk. While this is true, I would also like to observe that individuals influenced by the House Money Effect (when in the red) will often take extreme gambles with their investments in an attempt to recoup a loss. This is because “gambler” personality investors are often incorrectly quantified relative to risk aversion. They are not “risk” averse in the traditional sense—they are loss averse.

These loss averse investors are comfortable with high levels of volatility with their decision-making in order to no longer be at a loss. Thus, these individuals are “risk averse” in the sense that being in the red is a “risk.” Their sense of risk is oriented based on their net position and are so risk averse that they take highly volatile positions to escape a loss. Despite being contradictory from a definition perspective, from a behavioral finance angle this type of investor logic unfortunately checks out and is all too common in cryptocurrency markets (or casinos) where volatility abounds.

If you are a high-risk individual, understanding your loss aversion profile is paramount to becoming a safe and consistent investor. Financial discipline means being able to walk away from the charts if you have the “sudden inspiration” to immediately make a purchasing or selling decision. If your gut instinct is telling you to make a decision right this moment, this should give you immediate pause.

If the impulse decision is truly a solid fundamental long-term play, then waiting twenty-four hours will not drastically change the playing field. What twenty-four hours does is give you the opportunity to objectively pause and evaluate the following set of questions: Have the fundamentals of the asset changed? Has the narrative changed? What does the most recent investment journal entry target and why?

If you are a high-risk individual reading this book, the one thing I would have you walk away with is, before you make any split-second decision, pause and force yourself to walk away and come back in twenty-four hours. No, not fifteen minutes or thirty minutes. Twenty-four full hours.

Dr. John Grohol, CEO and founder of Psyche Central, suggests that unconscious thought, contrary to the way many of us think about it, is an active, goal-directed thought process. The primary difference is that in unconscious thought, the usual biases that are a part of our conscious thinking are absent. In unconscious thought, we weigh the importance of the components that make up our decision with greater equity, leaving our preconceptions at the door of unconsciousness. If you detach yourself from the situation with a full night of rest, you will realize the vast majority of decisions are tainted by your emotions or by one of the cognitive biases explored in this chapter. Stick with your principles and your long-term price targets for your buying and selling decisions. Don’t trust sudden inspirations.

The corollary to sudden inspirations is individuals who make no decisions at all. Loss averse individuals psychologically abhor selling at a loss so much that they hold onto losses for far too long. Shawn Russell was a prime example of this. Instead of cutting losses on the way down, Shawn was so loss averse he couldn’t stand to cut his losses. Anecdotally, loss averse investors, especially those with minimal investing experience, typically don’t have long-term price targets.

Shawn Russell is a perfect example why having a preplanned price strategy (using our investment journal) is imperative. What does this look like in action? Simple. “If this asset falls to x price as per my investment journal valuation, I am selling no matter what.” I have found that individuals without exit plans tend to be loss averse individuals who believe they can just ride out the market. They use an extremely long time horizon as an excuse for bad decision-making.

Unfortunately, the time value of money comes in to play here. Experienced investors will tell you to follow an exit strategy and reallocate your wealth to a different asset that will grow your overall net worth. Time and money invested in a slowly sinking asset are way more expensive than is immediately evident because of the opportunity cost that grows from the time value of money. Don’t sit with losers for too long. Selling at a loss is okay. It will happen, and you will be much better off in the long run by being willing to exit at a loss as opposed to refusing to ever exit at all. In addition, exiting at a loss will allow you to potentially repurchase the asset at a lower price, growing your overall position. Loss is not a permanent scar on your overall portfolio—you can recover if you give yourself the chance.

Transitioning to the Winner-Loser Effect, we find a close sibling of loss aversion. The Winner-Loser Effect is the phenomenon of security analysts, financial “experts”, pundits, and individual investors showing a bias toward recent successes in their predictions and investments. This makes “logical” sense in that something we believe is having a series of successes will naturally continue to have success. While generally this statement could be seen as true, it is the rate of predicted successive successes that gets twisted. The inverse is also true: the rate of predicted successive failures for losing investments tends to be drastically overestimated.

In 1997, the International Monetary Fund released “Winner-Loser Reversals in National Stock Markets: Can They Be Explained?” evaluating the Winner-Loser Effect on national stock market indices over the course of the previous decades. DeBondt and Thaler in 1985 were the first to identify the Winner-Loser Effect. Since then, a variety of other research has proven the legitimacy of this trend that good assets/indices will continue to do well, and bad assets will continue to do bad over the course of ten to twenty years. The problem, then, is, When does this ten to twenty-year period begin? Investors who fall prey to being biased by the Winner-Loser Effect will only be right (or wrong) in hindsight.

A variety of “technical analysis” experts will encourage the viability of “momentum” over long-term time frames based on these studies, but giving too much decision-making clout based around this idea is dangerous. The crypto sphere has an obsession about blockchain protocols releasing news. Investors drool over announcements, marketing campaigns, and public media because they feed right into the Winner-Loser Effect cognitive bias for both winners and losers. This is why you must track deadlines of project timelines and adjust your pricing expectations and predictions based on the actual fundamental progression of a blockchain project.

This chapter’s topic could easily be its own separate book. A vast wealth of information is out there that I would encourage you to pursue. Beyond Greed and Fear is a book I believe every investor must read before they spend a single penny in any volatile market. I wish I would have read it before I started on my path as an investor because it showed me just how complex and irrational every single human being is. Add financial stakes and complex markets with high amounts of volatility (e.g., crypto assets), and you are left with an environment ripe for emotional decision-making.

Reader, the better you know yourself and your tendencies, the more likely you will be able to spot impulse decisions and stop yourself in your tracks. Learn to recognize and discern your best and worst qualities as an investor and I promise you will be financially, psychologically, and emotionally better off. Yet investing effectively is more than just being able to identify the best and worst in yourself.

Ultimately, in the blockchain investment sphere is an arms race among informed and misinformed individual investors (all impacted by cognitive biases to varying degrees) who are desperately trying to recognize undervalued and overvalued blockchain projects. The next chapters will take the deep dive into walking you through the set of variables, factors, people, metrics, and qualitative information that will help you accurately inform your investment decisions.

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