Investors perform analysis in two forms, generally: Fundamental analysis and Technical analysis. Fundamental analysis seeks to take advantage of price discrepancies by projecting the value of the asset against the market price. Technical analysts will look at charts and try to seek patterns. Technical analysis is looking to capitalize on behavioral biases known to sway investors to act in a certain manner.
Following up on last weeks post about supply and demand forces in markets, we will ask the question why does supply and demand change over time by travelling one level deeper and focusing on human biases.
Biases can be divided into two subcategories: Cognitive biases and Emotional biases. Cognitive biases are the erroneous processing of statistical information (aka blind spots). Emotional biases are the illogical or distorted reasoning errors humans tend to make. We will look at the cognitive biases: availability, anchoring, and hindsight biases, as well as the emotional biases: loss aversion and endowment biases.
The first of which is availability bias, where known probabilities seem more likely to happen . This can easily be seen with lotteries and gambling around the world. Very small probabilities are hard for humans to process and with the help of media, we perceive these winning outcomes to happen more often than they actually do.
Anchoring is the attachment to an initial, default number. Whether setting the sale price to a round number or trying to squeeze a small profit above the cost the asset is bought, we set a reference point and have a difficult time adjusting our bias when factoring in new information.
Hindsight bias: everything in the rearview mirror is 20/20. Nothing bothers me more than the misrepresentation of “flipping” NFTs. Videos claiming the owner bought an NFT for $X00 and flipped for $X0,000, making a 100x gain in a short period is infuriating because the odds of this happening are near-zero. For every successful project that 100x, there are thousands that go to 0.
Loss aversion is the impulse to avoid losses more so than to acquire gains. Famously coined by Amos Tversky and Daniel Kahneman, they empirically showed that humans feel, on average, about 2x more pain for an equivalent unit of gain. In other words, the average person would feel about twice the pain losing $100 than the joy of finding $100. This is evident when we are hesitant to realize a loss and will hold a losing position.
People who are subject to endowment bias place more value on the asset they own than the equivalent asset they do not own. A rational person should value the asset equally whether one is buying or selling it.
In a typical hype NFT project, hopefuls enter with the dream of minting a rare item due to the hindsight bias from social media videos claiming 100x returns in a matter of minutes, creating a FOMO-type emotional reaction. Pre-reveal items are held with the anticipation of minting and flipping a rare item. With the help of availability bias, holders irrationally expect a larger probability of a the once-in-a-lifetime payout than what is realistic. Once the reveal takes place, the common item-holders see a drastic fall in expected value and may try to sell the item to avoid the discomfort of holding a loser. Whether or not the item actually turns out to be valuable, holders will value their item more than the going market price (as per endowment bias). Others will undercut the floor price, but some may not sell as they are anchored to a higher price. As the floor price continues to drop, loss aversion kicks in and most holders will post their item for the anchored price at which they bought it, to avoid the pain of realizing a loss. The price may then continue to drop below the mint price. Owners may never actually realize a sale unless the price picks up again very suddenly, like when a whale sweeps the floor.
Hopefully, by being aware of your biases, you can make more rational decisions and realize profits.