Crypto-Psychology: Irrational Behaviors in Digital Currency Markets Part II
This is the second part of an article that explores some of the patterns of irrationality that are starting to emerge in the cryptocoin space. In the first part, we presented two competing theses that attempt to explain the behavior of public markets. The efficient market hypothesis(EMH) pioneered by Eugene Fama states that market tend to push the price of any security towards its intrinsic value. Another school of thought has its roots in the cognitive psychology field with the work of Daniel Kanehman and Amos Tversky as well as economists like Richard Thaler and states that market participants exhibit irrational behaviors when making decisions. The irrational market hypothesis(IMH) has become extremly popular in financial markets and can certainly be used as a reference point to explain the irrationality of digital currency markets. In order to understand IMH in the context of cryptocurrencies, let’s explore five common patterns that we are seeing in the current market.
5 Patterns of Irrationality in the CryptoCoin Space
The irrational behavior of digital currencies is one of the aspects that makes institutional investors skeptic about the space. Like in any other financial markets, IMH details different patterns of irrationality that explains behaviors that puzzle many experts in the cryptocoin space.
1) The Illusion of Validity
This behavior explains how, many times, we maintain beliefs even if they don’t match the evidence. For instance, during last week, many people posted interesting articles explaining the recent drop and desaceleration in the price of Bitcoin. The explanations ranged from a sellout due to the holidays to the impact of the recently implemented futures contracts. Despite the intriguing arguments, most of the explanations were entirely subjective and lack analytic rigor.
Imagining correlations or patterns in datasets where they simply don’t exists is another key bias in human reasoning. In recent weeks, several small-cap companies have rebranded their message to indicate that they are getting into the Bitcoin mining business in order to drive the price of their stocks. My favorite example in the Long Island Ice Tea Company that, after including the word blockchain as part of its new name saw its stock raise a large multiple.
3)Power of Suggestion
More often than not, traders follow the opinions of others even if it clearly contradicts the evidence. Nothing moves the price of Bitcoin and digital currencies like news. Just yesterday, the announcement that Peter Thiel has been buying Bitcoin for years was enough to move the price of the cryptocurrency to the $15,000.00 level.
4)Status Quo Bias
This behavioral pattern explains how often we prefer to hold onto things rather than switching to a better alternative. Last year, Ether,LiteCoin and Ripple(XRP were far better trades than Bitcoin in terms of profitability. However, retail investors kept rushing into Bitcoin or holding onto their positions mostly influenced by the press coverage received by the cryptocoin.
The immediacy effect bias explains, how we are willing to pay more for an item when it causes a visual impact. One of my favorite examples of this behavior is the recent increase in the buy activity in Ripple(XRP) and LiteCoin in the last two weeks of the year. A large percentage of the buyers were people that originally signed up to exchanges like Coinbase with the idea of buying Bitcoin given its rapid raise towards $20,000.00. However, after seeing the high price of Bitcoin and without knowing that you could buy just fractions of a Bitcoin they went for cryptocurrencies like Litecoin or XRP that looked cheaper even if the Bitcoin trade was better during those two weeks.