Do you dare to buy cryptocurrencies? – Part 1

Do you dare to buy cryptocurrencies? – Part 1


By Adolfo Morán

Senior Lawyer at EY, Executive Director at Lawgic Tec  and Blogger at The Crypto Legal

In recent years, cryptocurrency fever has been on the rise. Many items have focused – naturally – on the financial aspect, giving advice on when is the best time to acquire or sell cryptocurrencies in order to make a profit. However, in this article, the author analyzes the purchase of cryptocurrencies from the behavioral approach[1]  describing what are the cognitive biases that influence the purchase. The item will be organized into two deliveries. This first will expose the biases that determine the first-time acquisition of cryptocurrencies such as bitcoins and/or ethers, while the second will expose the biases present after the acquisition.

Erik Finman is a young American who, when he was just 12 years old, made a decision that would change his life forever. In 2011, Erik received $1,000 from his grandmother to invest in his education. However, instead of investing them in books, he chose to buy bitcoins, which by then its value did not exceed 50 US dollars for each bitcoin.

What happened to Erik Finman seems obvious. He became one of many millionaires who decided to buy bitcoins in their first years of appearance. Today, despite losing faith in Bitcoin[2],he benefits from that youthful outburst that led him to bet all the money his grandmother gave him for a technological innovation that was, at thetime, mostly used in black markets operated on the Deep Web[3].

After reading these initial paragraphs, it has surely come to mind “how lucky thatboy’s” will come to mind and the second thing that will come to us will be “is now a good opportunity to invest in cryptocurrencies?”. For those who have read or heard these “night-morning” crypto-millionaire stories, they have surely been moderately aware of the price of bitcoins and one that other popular cryptocurrency, for example, the ethers of the Ethereum protocol.

No one has the answer to this question. The only truth – a basic rule – for all those who invest in cryptocurrencies, not trading, but simply storing cryptocurrencies until they expect their price to rise (the famous “hodlers”[4])is “cheap buy and sell expensive”.

The technology behind Bitcoin and Ethereum (and other crypto-projects) is innovative and disruptive, not for nothing large companies are behind these projects to leverage such technology in their internal processes and offer productsand services [5]. However, most people see these digital currencies only as a means to make a lot of money.

This is not the first time people have suffered from this speculative “fever.” Already in the seventeenth century the “Tulipomania” was lived in the Netherlands What was it about? The Dutch were amazed by the tulip bulbs that had been brought from Turkey, then the Ottoman Empire, especially since it turned out that the Dutch lands were suitable for the flowering of this plant, which did so in different colors.

This new exotic product was coveted by the Dutch high class at the time, which soon became a symbol of wealth. The growing demand for tulips caused the price of this plant to soar into many millionaires by selling their tulip bulbs at an excessively expensive price.

Why did the Dutch take an interest in tulips? A mixture of economic bonanza and an unprecedented interest in the exotic may have been the factors that triggered this financial bubble; However, if we delve a little de further we can appreciate that we are facing cognitive biases.

The Dutch saw in selling tulip bulbs a quick way to make a lot of money, just as many people see in cryptocurrencies as a quick way toget rich.  The interesting thing about this is that many of these (unsophisticated) investors intend to make money without having any basic knowledge of investment strategies or investment portfolio management, but simply guide themselves by what most people do, under the premise “if it worked for him why wouldn’t it work for me?”

This is a cognitive bias known  as herding or    herd behavior,which alludes to acting based on eachother’s act; that is, I decide to invest because another has invested before me, then I imitate it. This cognitive bias is very common in financial markets and even more so among unsophisticated investors who often make investment decisions only based on the recommendations of another; for example, by means ofsignals[7].

A fundamental reason for herding  in the cryptocurrency market is due to the lack of reliable information. It is very common for people who wish to purchase a particular cryptocurrency – possibly, at best – to have visited a few websites and viewed some forums (e.g. Reddit or Bitcoin forum) to decide whether or not to buy cryptocurrencies.

From that moment on, a series of cognitive biases enter the scene. Once you have visited some pages on topics like “Should I buy cryptocurrencies now?”, “How much is the estimated value of bitcoin by the end of the year?”, you will find that there are gurus who will advise that “now is the appropriate time to buy bitcoins, since the price has dropped and, according to my technical analysis (or simply because I did well before), I KNOW that we will soon enter a bull market”.

 

The gurus in the cryptocurrency market are from those known in the tech world such as John McAfee (yes, the same antivirus), who predicts that a bitcoin will be worth US$1 million by 2020, such as the aforementioned crypto-millionaires[8].

It is very certain that, in the face of the disrecognise and hype of  the moment, the interested buyer will decide to invest based on what any of these gurus say; we will then be faced with the bias of obedience to authoritybias. This bias is quite simple and we observe it in many areas (religion, work, school, etc.). In this case, the interested investor will buy cryptocurrencies only because a guru (the authority) pointed out on their social networks that it is the right time to buy, for example, bitcoins.

Once we have read a sufficient number of websites about cryptocurrencies, as well as having researched the bios  and recent tweets of different gurus, we will surely decide to buy a few cryptocurrencies with the determination to become in a few months in crypto-millionaires. We will be convinced that NOW IS THE TIME.

Then we will surely enter one of the known  cryptocurrency exchanges, such as Coinmama.com, and buy our first cryptocurrencies with ourcreditcard [9]. We will verify, after a few minutes, that the amount purchased is now recorded in our cryptocurrency wallet; then, all that remains is to wait and wait until the value of our cryptocurrencies increases at stratospheric prices.

Two cognitive biases are present once we decide to buy, as we are sure that now is the perfect time to do so. The first is the overconfidenceeffect bias and the second isoptimisticbias.

As Kahneman and Riepe (1998) identified, these two cognitive biases are common in investment decisions. In this case, after reading several pages that we self-qualify as “high quality” we will feel quite confident to buy the first cryptocurrencies; it is not necessary to consult with specialists, but it is sufficient to analyse all the information collected to make the right decision.

Finally, the last bias present in the cryptocurrency buying operation is optimism,a very important component todecide to buy; that is, “others will have lost money for bad decisions, I have made a good decision and I only have to wait until (someday) my cryptocurrencies are valued enough to sell them and become a millionaire”. As long as optimism lasts, there will be no problems.

We have identified four cognitive biases present in those unsophisticated investors (who are the majority) of cryptocurrencies: herding, authority bias, overconfidence effect  and  optimism bias. I am aware that we may be facing other additional biases, however, these are some of the most important.

Now that we know that our cryptocurrency investment decisions are bias-based, it remains to be defined whether there are also biases present in cryptocurrency sales; that is, the biases related to the dilemma of continuing to store my cryptocurrencies waiting for them to appreciate in time or sell them now that I have won a little or not lost much. This will be the subject of the development of the second installment. Don’t miss it.

*Originally published  www.enfoquederecho.com, in thePsychoLAWgy column.

PAGE NOTES:

[1] This article takes as a starting point the biases described by Patrick Oberstadt in a short but rather enlightening article. However, what is written here will develop other biases present in the investment decisions in the cryptocurrency market of those mentioned by that author. You can see here the article mentioned:  https://medium.com/crobox/6-psychological-biases-youll-experience-when-it-comes-to-trading-cryptocurrency-8c7490086774

[2] Despite having been a staunch advocate for Bitcoin in recent years, in a recent interview, clearly affected by the bad year in cryptocurrency prices, he stated that  “Bitcoin is dead in the long run.” For more information see:  https://es.cointelegraph.com/news/teen-bitcoin-millionaire-erik-finman-proclaims-bitcoin-is-dead-long-term

[3] The best-known case was the drug and weapons marketplace operating on the Deep Web whose name was Silk Road. Its founder Ross Ulbricht, known as Dread Pirate Roberts, was arrested by the FBI and is currently in jail. The purchase on this marketplace was made with bitcoins. For more information see:  https://www.forbes.com/sites/andygreenberg/2013/08/14/meet-the-dread-pirate-roberts-the-man-behind-booming-black-market-drug-website-silk-road/#1c2e4d788b73

[4]   Hodlers are said  to those investors who buy cryptocurrencies and keep them expecting them to appreciate them and then sell them and generate profits. This word, along with hodl, arose from a user’s “typing error” on the Bitcoin Forum forum; that is, hodl would be the hold word of the English language.

[5] For example, in the case of Ethereum there is the Enterprise Ethereum Alliance, which is composed of more than 380 members, among which are Microsoft, BANCO BBVA and T-Mobile. For more information see:  https://entethalliance.org/members/

[6] This is due to the volatility of digital currencies, with bitcoins being the paradigmatic case. For example, at the beginning of February 2017 a bitcoin cost about US$1,000, if a person bought 10 bitcoins at that price, by December 17 of the same year their bitcoins would be worth about 200,000 thousand U.S. dollars.

[7] Signal service is very common in forex and cryptocurrency markets. This service consists of an  experienced trader  (or sometimes  a bot) sendingsignals for the investor to place the buy or sell order on platforms or cryptocurrency exchanges,  such as Bitfinex. The problem with this service is that it promotes un-informed investment decisions based only on another’s technical analysis, which can often fail. For more information on signal service:  https://www.babypips.com/learn/forex/signal-services

[8] I have to do a  disclaimer. I do not intend to point out that there are no serious traders or gurus, who are actually promoting the use of cryptocurrencies or performing analysis of this market professionally (e.g. Andreas Antonopoulos); however, with the help of social networks, today there are many pseudo gurus or traders who do not contribute to the development of this market, but often influence people to be wary of technology.

[9] Many people often buy cryptocurrencies with credit cards. View:  https://www.bloomberg.com/news/articles/2018-01-11/bitcoin-buyers-turn-to-credit-cards-as-fomo-breeds-risk-taking

Bibliography:

Publications:

BALCILAR, Mehmet; Riza DEMIRER and Shawkat Hammoudeh. (2012)  Investor Herds and Regime-Switching: Evidence from Gulf Arab Stock Markets. Retrieved from:  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2147709  Visited on January 10, 2019.

CIALDINI, Robert B. Influence: The Psychology of Persuasion. Harper Collins e-books. 2006.

KAHNEMAN, Daniel and Mark W. RIEPE. (1998) Aspects of Investor Psychology: Beliefs, preferences and biases investment advisors should know. In: Journal of Portfolio Management, Vol 24, No. 4 pp. 52-65.

POYSER CALDERON, Obryan. (2018) Herding behavior in cryptocurrency markets.  Retrieved from:  https://arxiv.org/pdf/1806.11348.pdf  Visited on January 10, 2019.

SALEH, Mohamad. (2018) Cryptonomics: Investment behaviour in the cryptocurrency market. Extracted from:  https://www.academia.edu/37876981/Work_in_Progress-_Cryptonomics_Investment_behaviour_in_the_cryptocurrency_market

Blog post:

HOCHMA, Tomer. The Ultimate List of Cognitive Biases: Why Humans Make Irrational Decisions. Retrieved from:  https://humanhow.com/en/list-of-cognitive-biases-with-examples/Visited on January 19, 2019.

BABYPIPS. Forex Signals. Retrieved from:  https://www.babypips.com/learn/forex/signal-services  Visited on January 19, 2019.

LEINZ, Kailey. (2018) People Desperate to Buy Bitcoin Are Paying with Credit Cards. Extracted from:  https://www.bloomberg.com/news/articles/2018-01-11/bitcoin-buyers-turn-to-credit-cards-as-fomo-breeds-risk-taking

OBERSTADT, Patrick. (2017) 6 Psychological Biases you’ll experience when it comes to trading Cryptocurrency. Retrieved  https://medium.com/crobox/6-psychological-biases-youll-experience-when-it-comes-to-trading-cryptocurrency-8c7490086774  Visited on January 10, 2019.

REZAIEZADEH, Siamac. (2017) The Authority Bias – Cognitive Bias Review Part VII. Retrieved from:  https://smallbusinessforum.co/the-authority-bias-cognitive-bias-review-part-vii-5266ef075800  Visited on January 20, 2019.

Press articles:

GREENE, Tristan. (2018)  Erik Finman is a Bitcoin millionaire: Now what? Retrieved from:  https://thenextweb.com/hardfork/2018/08/14/erik-finman-is-a-bitcoin-millionaire-now-what/  Visited on January 08, 2019.

GREENBERG, Andy. (2013) Meet The Dread Pirate Roberts, The Man Behind Blooming Black Market Drug Website Silk Road. Retrieved  https://www.forbes.com/sites/andygreenberg/2013/08/14/meet-the-dread-pirate-roberts-the-man-behind-booming-black-market-drug-website-silk-road/#da463318b735  Visited on January 11, 2019.

HULLIET, Marie. (2018) Erik Finman, Bitcoin Teen Millionaire proclaims that Bitcoin is “dead” in the longrun. Extracted from  https://es.cointelegraph.com/news/teen-bitcoin-millionaire-erik-finman-proclaims-bitcoin-is-dead-long-term. Visited January 10, 2019.

WALL, Jeremy. (2018) McAfee Stands By $1 Million Bitcoin Price Prediction By 2020. Retrieved from:  https://www.investinblockchain.com/mcafee-bitcoin-price-prediction/  Visited on January 20, 2019.