Crypto Psychology: Irrational Behavior in Digital Currency Markets Part I
Happy 2018 readers! I hope this ne year brings you lots of blessings and happiness for you and your family. I would like to start the year by discussing some of the patterns that can be spot in digital currency markets that explain many of the irrational behaviors in the space. Those patterns have been well established in the field of behavioral economics but they still result fascinating when perceived through the lenses of the cryptocoin markets.
A Tale of Two Market Hypothesis
In financial markets, there are two main theories that have become the favorites of economists in order to explain the often puzzling behavior of financial markets. The first of those theories dates back to 1970 and a young economist named Eugene Fama. In his doctoral thesis, Fama defined the idea of an “efficient market” as a place in which “ competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which as of now the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value”.
Fama’s efficient market hypothesis(EMH) has triggered nearly 50 years of controversy as well as important contributions to portfolio theory such as the Black-Scholes-Merton formula which became the north star of financial markets for years and resulted on a Nobel prize for Scholes and Merton(Black died before the prize was awarded). Most notably, Fama’s theory led to the creation of EMH- purist funds such as the infamous Long Term Capital Management(LTCM) which included Scholes and Merton on its staff and went on to post impressive profits for a couples of years before its dramatic collapse in 1998. In essence, EMH predicts that markets are unpredictable as any information is already known finds an organic way to be priced into a security.
A challenging hypothesis to Fama’s EMH proposes the idea that market participants will act irrationally despite the information they have access to. The idea of irrational markets has its rooms on the work of psychologists Daniel Kahnenman and Amos Tversky which created the roots of the field of behavioral economics. Kahneman and Tversky work eventually expanded into economics guided by brilliant minds such as Richard Thaler which was awarded the 2017 Nobel prize in economics. The irrational market hypothesis(IMH) states that market participants make decisions based on reasons that have little to do with statistics and more related to emotions. In other words, market participants tend to behave irrationally.
The classic example of IMH is the fear-of-missing-out(FOMO) behavior that rush investors into or out of a security together greatly amplifying its risk. As James Buchan cleverly put in his book Frozen Desire, investors buy or sell a security based on the hope, not the knowledge, that it will go up or down.
Most people agree that digital currency markets behave quite irrationally but what are the specific behaviors that exemplified that irrationality? That will be the subject of tomorrow’s post.