Avoiding The Behavioral Pitfalls of Bitcoin

Bitcoin has taken over the world and there are critical measures that investors need to be aware of, writes Paul Nixon, head of behavioral finance at Momentum Investments.

avoiding the behavioral pitfalls of bitcoin

Love it or hate it, Bitcoin appears to be here to stay. Having attracted over a trillion dollars of investment, this article is less about the merits of investing in Bitcoin and more about how to avoid the clear behavioural pitfalls that lie in waiting should you decide to allocate a portion of your investment portfolio to the digital currency. This will help investors avoid the dreaded behaviour tax. A “behaviour tax” is lower investment returns directly linked to an investor’s behaviour, like switching between investments either due to fear (when markets are turbulent, for example) or greed (being attracted by the performance of a different investment).

1. Echo chamber syndrome

Firstly, when doing their homework, investors should ensure that whatever their view on Bitcoin is, they should actively seek an opposing view. The challenge with social media is that algorithms are geared to surface content we like, thereby quickly placing us in an echo chamber that reinforces our views. There are many smart people who are Bitcoin advocates and many who are not. Get a diversity of views in coming to a conclusion about the digital currency.

2. The market turbulence trap

Beware of creating a behaviour tax by becoming overly connected to the value of the portfolio. Even the biggest advocates of Bitcoin will advise that this is an investment for the long term, and possibly even for the next generation. Steer clear of regularly logging in to check the value.

3. Overconfidence

When the price increases, you will feel very smart. This doesn’t mean you were necessarily right, or at least for the reasons you thought. It is very easy to get overconfident and then allocate more to the position than is responsible.

4. The disposition effect

This bias is a combination of loss aversion and regret aversion. There will be a strong inclination to sell when the price increases to avoid the regret of the price trend reversing. The result is that investors often miss out on future gains. Loss aversion results in the trend of holding onto losing positions for too long in the hope they will reverse. This is combated by clearly establishing rules for trading decisions (if the goal is to make profits from buying and selling). The rules are established when you are thinking clearly so you don’t react emotionally to market news. Trading is, of course, a very different game to investing.

5. Hindsight bias

The world always seems more predictable in hindsight. Towards the end of 2022, Bitcoin was trading at around $16 000 and recently it has once again reached new highs. Don’t forget that after the FTX debacle, a cryptocurrency exchange that went bankrupt, there was a risk that continued downward pressure suffocated any revival permanently. The price recovery was not predictable and there is real uncertainty inherent to digital currency (unknown unknowns).

Financial advisers should be guiding those clients who would like to invest in Bitcoin on some sound principles. In general, the higher the uncertainty of future returns, the smaller the share of the prospective investment should represent in the overall portfolio. Uncertainty is distinct from volatility. Volatility is a feature – it works both ways (up and down), but uncertainty is the unknown unknowns (like the FTX debacle) that could take the value of a portfolio down significantly, either temporarily or permanently.

While institutional adoption of Bitcoin has decreased both uncertainty and volatility, there is still much that is unknown. Bitcoin has a relatively high production cost in converting energy (the chips used to solve complex mathematical problems) into Bitcoin. Added to this is that the blockchain to date is not equipped to handle even a fraction of what Mastercard, for example, handles daily. These are but two factors contributing to uncertainty or unknowns about the mainstream adoption of Bitcoin, meaning clients, and if they did their homework, should be conservative in allocating money to Bitcoin.

A conservative approach towards Bitcoin, together with consideration of the behavioural pitfalls of investing in Bitcoin, should set the investor up to avoid a behaviour tax.

Paul Nixon, head of behavioural finance at Momentum Investments
Paul Nixon, head of behavioural finance at Momentum Investments

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