Outsmart Yourself: Become a Better Crypto Trader by Avoiding the Top Cognitive Biases

The DeFi Edge runs down four of the most mental hang-ups affecting crypto traders.

AccessTimeIconOct 24, 2022 at 12:46 p.m. UTC
Updated Nov 7, 2022 at 5:28 p.m. UTC
AccessTimeIconOct 24, 2022 at 12:46 p.m. UTCUpdated Nov 7, 2022 at 5:28 p.m. UTCLayer 2
AccessTimeIconOct 24, 2022 at 12:46 p.m. UTCUpdated Nov 7, 2022 at 5:28 p.m. UTCLayer 2

Your brain can be your worst enemy in trading.

You like to think you’re rational and objective about every decision, but that isn’t true. Here’s the problem: Your attention is limited in an increasingly complex world.

The DeFi Edge is the writer of “The DeFi Edge” newsletter focused on the latest trends and narratives in crypto. This article is part of CoinDesk's "Trading Week."

The brain’s lazy. It likes to conserve energy and find shortcuts whenever possible. And, sometimes, that leads to oversimplifying information to the point where it’s wrong.This leads to cognitive biases. Cognitive biases are judgments we form based on our experiences and beliefs rather than objective evidence. These biases can lead us to make bad decisions, especially when trading in financial markets.

Source: Tim Isaksson/Wikimedia

To become a better trader, you have to think more logically. Understanding what cognitive biases are and overcoming them is one of the easiest ways to improve your performance. There are hundreds of cognitive biases out there. Where should you begin?Let’s start with the four biggest ones that affect every crypto trader at some point.

1. The action bias

The action bias describes our preference for taking action over inaction. It’s the feeling that you always have to do something.

I used to play a lot of poker. One common leak is the feeling that you must play every single hand. Maybe it’s boredom or people want the dopamine hits. Sometimes the best thing to do is to wait until you have a better starting hand.

That’s how I feel now about the bear market. It’s a more challenging market to trade in, and it can sometimes feel like player vs. player. Instead of trying to trade with so many headwinds against you, try waiting. You might be better off leveling up your skills and waiting for a better macro environment.

2. The anchor bias

The anchor bias describes how you over-rely on the first piece of information you see. All decisions are silently “anchored” to the first point. This is a commonly used strategy in the world of fashion. The shirt starts off at $100, a few months later it goes on “sale” for $50.

It feels like you’re getting a good deal because you’re comparing it to the $100 price tag. Would you feel like you were getting a good deal if you knew the shirt cost $5 to make?

The anchor bias occurs in crypto all the time.

  1. You heard about bitcoin at $1,000 and didn’t invest. It goes up to $5,000. You don’t want to buy anymore because it’s too expensive, in your mind. But that’s because you’ve anchored it to $1,000. What if you believe it’ll go up to $100,000 one day?
  2. A token peaked at $200 a coin. Now it’s at $15. Your gut instinct says it’s a good deal. But all that’s in the past. How does its road map look now? What developments has it had since the peak price?

Evaluate it based on its potential rather than its past.

3. Confirmation bias

We all want to be right. Confirmation bias is the tendency to seek out information that agrees with it. You keep reinforcing what you already believe. This is the most dangerous bias of all.

Let’s say you’re interested in buying a token. You want to believe it’ll do 100x, right?

  • You only follow people who say good things about a specific token.
  • When negative data appears about that token, you blame that on FUD (fear, uncertainty and doubt).

You’ve locked yourself into an echo chamber.

4. The sunk cost bias

When people spend a lot of effort on something (including money), they won’t back down even if it goes wrong. We tend to overcommit because we’re scared of losing the original investment and selling it is kinda admitting that you were wrong. Don’t throw good money after the bad. If you’re down 70% on a token, you still have 30% left. It might be worth salvaging the last 30% instead of seeing it go down further.

Just because you spent time or money doing something doesn’t mean you should keep doing it. Ask yourself: “Knowing what I know now, would I make the same decision again?”

How can you stop cognitive biases?

To avoid letting these biases impact your trading decisions, you must be aware of them and consciously try to counter them. Study the biases. There are hundreds of biases out there. Start by studying the works of Daniel Kahneman.

  1. Reflect: Think about some of the mistakes you’ve made in crypto. How many of them were caused by cognitive biases?
  2. Create a checklist: Whenever you make an investment decision, you go through it. It’ll keep you aware of thinking flaws.
  3. Develop systems: Systems are a set of processes and decision-making criteria. For example, determining when you’ll cut losses or take profits before you enter the trade. Once you’re in the trenches, it’s easy to become emotional.

Remember that no matter how diligent you are with recognizing and combating cognitive bias, you cannot be immune from its influence altogether. Everyone makes mistakes, so don’t beat yourself up if something goes wrong in your trading career. Focus instead on learning from it and moving forward.

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The DeFi Edge

The DeFi Edge is a crypto commentator and educator and writer of “The DeFi Edge” newsletter focused on the latest trends and narratives in DeFi.