Most cryptocurrency & bitcoin traders and investors have the tendency to think they are right most of the time, even when they are wrong. This is caused by what is known in psychology as “cognitive bias”, which often leads to bad trading decisions. Bitcoin & crypto is a highly volatile market and bad trading decisions in this market will lead to losing money, over and over again.
The bad news is that you will never entirely overcome your cognitive biases, because it’s in our nature as humans. The good news is that once you are aware of your cognitive biases, you can stand a better chance at becoming a successful crypto trader.
What is a “Cognitive Bias”?
A cognitive bias is simply a tendency that leads our thinking away from a correct judgment. Here, are the most important biases that every trader or investor can relate to:
1. Confirmation Bias
So, let me take you as an example. You see a new cryptocurrency trending on social media. The crypto coin has already gone up 300% in just a couple of weeks, as the company announced a new product they are currently testing, that is showing great promise. You recall this company being mentioned on a major news source a couple of days ago. You go and “google” the company and looks for articles that would suggest the cryptocurrency might keep on increasing in price.
You find some articles confirming that the company’s new product will be a hit worth billions of dollars. You read all the positive comments about that company on different social media platforms. You then look at the chart and although the stock doesn’t fit your technical criteria and may be overextended or overbought, you recall that some TV analyst predicted a price of is $30 and the cryptocurrency is now trading at $10, so likely to at least triple from there.
You decide that all stars are aligned and this is the perfect chance. You put all your savings in that cryptocurrency and start thinking about the things you will buy with the profit. This is the confirmation bias: a tendency to actively seeking only information that confirms your beliefs, and you reject or disregard information that disconfirms your beliefs.
We all experience confirmation bias. How to overcome it? It’s hard and it’s up to you to recognize it and be aware that it affects your decision making process. The first thing a cryptocurrency trader should do, every time they enter a trade is to make a list of the pros and cons and reassess it with an open mind. Always consider the other side of the trade you take.
2. Self-Serving Bias
Let’s continue with your story. In the next days, the cryptocurrency you bought, decreases in value and goes against your position. Not only you have a losing position, but the crypto coin keeps going even more against you. However, you still believe that your reasoning is correct.
After all, you did some research, and TV analysts and social media confirmed your view. You are absolutely convinced that you are not wrong. The ones that sold the cryptocurrency are just amateurs and are selling the opportunity of a lifetime. You think to yourself that the crypto is probably being manipulated by investors wanting to buy some more at a lower price. You know that it will recover as soon as the market finally understands how company will be worth billions in the near future.
You see the problem here? You can only see information that fits your puzzle, regardless of whether the puzzle is correct or not. This is the self-serving bias: a tendency to focus your attention on the information that enhances your self-esteem and protects you from any negative feedback. Self-serving bias is also known as the attribution bias in some books. Basically, when things go well, it is because of you. When things go south, it is definitely not your fault.
After a fantastic trade with a nice profit, you start to feel like a genius, thinking that your trading skills made it possible. After a losing trade, you blame your broker, your computer, your chair, your zodiac sign. That’s the self-serving bias. The lesson here is to assume responsibility for everything, including your losses. As a cryptocurrency & bitcoin trader or investor, try not shift blame because it does not help you progress.
What does help? Taking responsibility to find out what went wrong. And doing what is needed to improve.
How to overcome it? Consider keeping an investment or trading journal. Reviewing a trading journal can help you easily identify strengths and weaknesses in your trading. It can also help you identify mistakes that you continually make. Also, it can help you to identify when and why your analysis was correct.
3. Hindsight Bias
The cryptocurrency you invested in, fell from $10 to $3 and your trading account gets a margin call. Unable to cope with the pain of that loss anymore, you finally realize your mistake. You start to recall all the red flags you noticed before buying the crypto coin. You remember that you saw many articles saying the company’s product was not ready yet and the chances of releasing it were slim. And on top of that, the cryptocurrency was clearly extended when you entered the trade.
After reflecting about it, it was clear in your mind that you knew this trade was going to be a loser right from the start. This is the hindsight bias: a tendency to represent the past not according to what you experienced, but according to what happened later. Hindsight bias can lead you to believe that an event was more predictable than it actually was.
4. Recency Bias
After a week, you see another opportunity. Another cryptocurrency with huge potential. There’s a lot of hype on social media about this crypto coin. It even fits your technical criteria, a no-brainer buy. But you lost money on the previous trade. Due to your recent experience, you decide to skip that opportunity, you’re afraid. That’s the recency bias: our brains naturally put more weight on recent experience and we avoid trades that remind us of our recent losses.
How to overcome it? Write out a trade checklist with your criteria from your trading plan. This way, you are more likely not to enter every trade unless it fulfills all of the criteria. You will enter a trade only if it matches your trading plan criteria, no matter if you had a losing or a winning trade before.
5. Illusion of Control
You are convinced that you have control and that’s why you increase your lot size. Nothing can go wrong. Thinking that you can control the outcome of your next trade, is the same as believing that you control the market. You clearly don’t. The illusion of control comes after a winning streak, and is extremely dangerous. You increase your lot size and when the trade goes against you, you increase your stop loss, because you absolutely know that you’re right.
And, you guessed it; you get a margin call after a winning streak. One bad trade can wipe out your entire account. The market doesn’t care you won 10 trades in a row. We work in uncertain conditions. Recognizing that we have no control over the market is the first step towards managing our risk.
The lesson here is to avoid seeking certainty and control. That’s why it’s better to focus on controlling what we can control. Our actions and emotions.
6. Bandwagon Effect
You buy a cryptocurrency because everyone else seems to be doing it, even when there are no good reasons for doing so. Another example is when you hear everyone saying that the bull market will stop soon. You hear words like recession and bear market. The news, gurus, and forums are all bursting with negativity.
You look at your charts with your technical analysis tools and you don’t find anything bearish. Then you look at several other cryptocurrencies and find some bullish setups. But because everyone was saying that the bull market would come to an end, you sell all your long positions and skip new long trades.
The outcome of the market does not matter, whether it continued to rise or fall. You have already joined the bandwagon bias because you follow the herd instead of your analysis. The lesson here is to listen to your own analysis, and ignore the voices of the masses.
I’m not saying you should adopt a contrarian mindset and always go against the herd. That is not the case. Just trust your own analysis.