Buying at ATH due to FOMO? Selling blue-chip coins for junk coins? Introduction to 14 cognitive biases, aiming to avoid losses

Due to the irrationality of human thinking, the rationality of decision-making is often influenced by individual cognitive biases, which can affect the subsequent outcomes. When this situation is applied to investments, it may lead to financial losses for investors. DeFi researcher The DeFi Edge recently compiled 14 common cognitive biases in investment, hoping to help investors make better financial allocation decisions.

This article is a translation and compilation of a tweet by The DeFi Edge. Original post here

What Is Cognitive Bias?

According to the definition on Wikipedia, cognitive bias is a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" based on their perception of inputs. How individuals construct their reality, rather than the objective input, may influence their behavior in the world.

When it comes to investment behavior, the following situations may indicate the influence of cognitive bias:

• Buying a cryptocurrency at its all-time high (ATH) due to Fear of Missing Out (FOMO)
• Selling high-quality cryptocurrencies to buy some low-quality ones
• Refusing to cut losses and take profits, resulting in further losses after already experiencing a 50% loss

14 Common Cognitive Biases

1. Unit Bias

People tend to buy "whole units" of a cryptocurrency rather than fractions, which is why meme coins can surge in value due to their low unit value. Do not overvalue the worth of a cryptocurrency just because its unit price is low; understanding market capitalization is crucial.

2. Anchoring Bias

Placing too much emphasis on the first piece of information received. For example, if you heard about Bitcoin at $1,000 but missed the opportunity, and it later rose to $5,000, you might hesitate to buy because it now seems "expensive" in your mind.

When evaluating a cryptocurrency, focus on its potential rather than its past performance.

3. Confirmation Bias

You only look for information that confirms your existing beliefs, follow positive narratives about specific cryptocurrencies, and unfollow or block those spreading Fear, Uncertainty, and Doubt (FUD).

When investing, seek out and research FUD to verify its accuracy.

Note: FUD stands for Fear, Uncertainty, Doubt.

4. Sunk Cost Bias

Costs that have been incurred and cannot be recovered are known as sunk costs.

People tend to continue or overcommit investments because they fear losing the initial investment.

For example, when watching a movie you don't enjoy, you might not leave the theater but sit through it because you've already paid for the ticket. However, whether you watch it or not, the ticket cost won't be refunded, and persisting to watch it through would only incur a time cost.

Similarly, in investments, when you've lost 70% of your capital and only have 30% left, it's important to carefully evaluate whether to reinvest or choose another asset. Blindly believing that the initial capital will bounce back is not rational.

5. Loss Aversion

The feeling of losing $100 is stronger than the feeling of gaining $100. Studies suggest that the difference between these feelings is about 2.5 times. The feeling of losing $100 is equivalent to the feeling of gaining $250.

For instance, when your investment in a certain cryptocurrency has already lost 50%, and more bearish news surfaces, you may consider cutting your losses immediately. However, due to loss aversion, some individuals might choose not to take any hedging actions because they fear selling at a "loss."

Loss aversion leads to risk aversion. In the world of DeFi, events like Rug Pulls often occur, causing some people to avoid investing in DeFi and missing out on profit opportunities in this sector.

Properly weighing risks and rewards is essential.

6. Recency Bias

People overestimate recent news and events.

"ETH prices have been boring lately; I'm going to chase after low-cap altcoins." But these coins are plunging in a bear market, and recency bias can be overcome by zooming out on the charts.

7. Overconfidence Bias

People overestimate their abilities due to a few lucky money-making instances.

The key to overcoming overconfidence is having sound risk management abilities.

8. Endowment Effect

You develop an emotional attachment to your investment portfolio because you own those coins, giving them higher value. Many extreme Ethereum maximalists exhibit this behavior, becoming emotionally attached to Ethereum due to significant gains and subsequently ignoring other Layer 1 blockchains.

To overcome this effect, ask yourself mentally: "If I didn't already have this investment target, would I choose to invest in it now?" This approach can help you make more unbiased and neutral decisions.

9. Survivorship Bias

Brad Pitt moved to Los Angeles and worked as a waiter before becoming a movie star. Many people try to emulate him and follow the same path, but they fail to notice the thousands who have tried and failed.

While some may turn $8,000 into $5.7 billion by investing in Shiba Inu, you won't hear about those who turned $8,000 into just $500. Media outlets prefer to report winners, thus distorting people's perception of odds.

10. Narrative Bias

People love stories, as they help us understand the world. Many cryptocurrencies surge in value due to compelling narratives, as seen in last year's GameStop event. It became a battle against Wall Street, and people invested based on this narrative.

11. Herd Mentality Bias

Many investors tend to follow or mimic the actions of other investors, largely influenced by emotions and intuition rather than independent analysis. If you've ever experienced Fear of Missing Out (FOMO), it's likely due to herd mentality.

12. Availability Heuristic

People make judgments based on the ease of remembering information. After significant airplane incidents like 9/11, people started to fear flying. However, only 1 in 9,821 people will die in a plane accident, while 1 in 114 will die in a car accident. Flying is much safer.

In the cryptocurrency world, availability bias often appears in marketing. If a cryptocurrency receives good marketing, the chances of a price surge increase significantly. While marketing is crucial, it's essential to ensure that behind it lies a solid project.

13. Outcome Bias

Outcome bias is the error in evaluating decision quality when the decision's outcome is known. For instance, in a Texas Hold'em poker game where you go all-in with AA against JJ, AA has an 80% chance of winning, but you lose. You made a good decision, but the outcome was unfavorable. Similarly, investing $10,000 in a meme coin that is now worth $100,000 may sound good, but it was a bad decision.

Looking at outcome bias from another perspective, if the same scenario were reevaluated 1,000 times, the differences must be measured. You can do everything right along the way, but the outcome may still not be favorable. Life is about making decisions based on the best odds and possibilities.

14. Authority Bias

Following leaders is human nature. When we view someone as an expert, we tend to believe everything they say. However, experts can be wrong or have ulterior motives.

How to Avoid Cognitive Bias

After understanding these 14 common cognitive biases, The DeFi Edge offers some advice to prevent these situations:

• Create a cognitive bias checklist. Whenever making investment decisions, refer to the cognitive bias checklist to make yourself aware of your cognitive flaws.
• Establish your own investment system, as formulas can help stabilize investment emotions.
• Use tools like Google Sheets to maintain a trading journal. Record not only financial data but also the arguments for your investments. If exiting early, write down the issues or reasons encountered.