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The Psychology of Loss Aversion and Crypto Market Volatility

crypto assets 2017

Humans tend to be loss averse. This means they would prefer not to lose a hundred dollars as compared to winning a hundred dollars. If we evaluate this phenomenon through the lens of gambling, investing, and trading, it seems weird.

In 2002, Daniel Kahneman, a Princeton professor who won the Nobel Prize in economics, and his collaborator Amos Tversky (who did not receive the Nobel Prize because he had passed away) performed many experiments to understand human shortcomings while making choices. They presented that even something as simple as a coin toss demonstrates our aversion to loss.

In an interview with the New York Times, Kahneman said, “In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?’

“People want more than $20 before it is acceptable. And now, I’ve been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll take the gamble.”

Basic human psychology has developed a form of fear, the fear of losing. But this fear directly affects the ability to gain in the crypto market. The dilemma for crypto traders is whether to buy a cryptocurrency or not given extreme volatility and the likelihood of losing their investment. If you fear loss, you would sell the coin in the first go and not wait for that pullback or a new high. Understanding and evaluating your gut instincts so that you can perform better as an investor or a trader is vital, especially in a volatile market like cryptocurrency.

Into the Crypto Market

Cryptocurrencies “should only be considered by those who can stomach potentially complete losses” says Richard Turnill, BlackRock’s global chief investment strategist. There are only a couple of million investors in Bitcoin and other cryptocurrencies. They reflect not even a small fraction of the total investing universe. But we also know as a fact that cryptocurrencies have made a lot of early investors multi-millionaires (if not billionaires). For a new entrant, the trick is to have the stomach to digest the volatility and wait for the fundamental adoption of blockchain into the financial universe. This is happening as we speak, and everybody, even Jamie Dimon, knows that blockchain is the future.

Enter Crypto Volatility

Cryptocurrencies in general, and Bitcoin in particular, are not for the fainthearted. Daily movements of 10%-20% up or down are a common occurrence with Bitcoin. Other currencies can be even more aggressively volatile. The graph below showcases the risk you take on when you invest in Bitcoin. An investor would have lost over 65% of his capital in just 50 days. So, does this mean that cryptocurrencies are for suckers?

Bitcoin volatility
Source: Hackernoon

On the contrary, cryptocurrency trading is a value game. Consider it like a startup that is slowly and steadily getting traction. You need to have a longer time horizon (like a VC) and make the long trade to wealthville. Consider this graph:

Bitcoin price history
Source: 99 Bitcoins

Bitcoin traded at a measly $10 in October 2012. A five-and-a-half year wait would have awarded your investment with a mindboggling 7,000% return. The small 65% pullback means nothing if you had bought at $10, $100 or even $1,000. If you want to see the 2017 hall of fame, check it out below:

crypto assets 2017

Bitcoin did well, but the larger crypto universe had even more eye-popping returns.

Speaking of Loss Aversion

Though there are a lot of early believers who have kept on holding (or have only partially liquidated) their crypto assets through the highs and lows, the investors who just joined the party might not be on the same boat. Their ability to appreciate crypto as an asset class for long-term growth potential would be difficult considering the majority of the hoopla is about traders cashing their stash for a “Lambo.” But this is the price adjustment that will differentiate the winners and losers of the market.

Consider the Winklevoss twins, made famous as the founders of Harvard Connect in the movie Social Network (the movie about the founding of Facebook), they hold an estimated 120,000 Bitcoins in their wallet and lost an estimated $1 billion in the current pullback. But these guys have yet to sell a single Bitcoin. They have seen the bigger picture and understand the potential of this digital gold.

What Should An Average Investor Do?

Greed and fear are the founding pillars of any market. It is okay to be greedy or fearful as long as you understand these emotions and how they affect your decision making. Loss aversion would be easier to manage if you have a proper plan and a timeline. If you are looking to speculate on a day-to-day, or a monthly, basis, then, yes, it might be time to get out of the market when the prices are high. But if you are looking to still make mega bucks, try to understand the core technology behind cryptocurrencies and how crypto applications are changing the face of business and economics in the world.

Your loss aversion can only be controlled if you believe in the long-term potential of what thousands of crypto entrepreneurs are trying to accomplish. Are all going to be the next Facebook? Absolutely not, but a well diversified portfolio with good strong names should give you substantial returns in the medium to long term.

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Written by Stephanie Vaughan.

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Allen Taylor

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