In the tumultuous landscape of bull and bear markets, it's easy to get swept away by the extreme emotions that accompany the rise and fall of fortunes. This was the crux of a Collective Cafe session I led, a deep dive into the psychological undercurrents that govern our behavior during market highs and lows.
Euphoria in Ascension, Despair in Decline
As of writing this piece, Bitcoin had surged to a record $65,000, Ethereum was inching towards its zenith, and though Solana trailed its peak, it’s recent rise has been super strong. The buzz was undeniable, except when it wasn’t. Just 6 months ago, our spirits were broken, our morale was “rekt” and our hope was non-existent.
The reason for this rollercoaster of sentiment? Six psychological phenomena that warp our rationality:
- Herd Mentality: The allure of the crowd can lead to a collective overconfidence, convincing us that the masses can’t be wrong, and the good times will never end.
- Overconfidence Bias: Past successes can inflate our egos, tricking us into believing we have the Midas touch in predicting market movements.
- Recency Bias: We give undue weight to recent events, allowing the latest gains to mask the risk of loss, or let recent losses cloud the potential for recovery.
- Loss Aversion: The fear of loss grips tighter than the thrill of gain, driving panic selling in downturns and paralyzing indecision when we should be seizing opportunity.
- Anchoring Bias: We tether our expectations to past highs and lows, sometimes misguiding our judgment of future potential.
- Confirmation Bias: We cherry-pick information that aligns with our hopes or fears, ignoring signals that might provide a more balanced perspective.
- Herd Mentality: The market often moves in herds, much like a school of fish or a flock of birds. There's comfort in numbers; when we see others investing with optimism, we're inclined to follow suit, convinced there's safety and wisdom in the collective. This herd mentality is a powerful force during a bull market, leading to a contagious euphoria. It feeds on itself – the more people buy, the higher the prices go, and the more others want in on the 'sure thing.' But herds can lead you off a cliff just as easily as they can to pasture. In a bull market, this instinct can blind us to warning signs, making the fall all the more surprising and painful when it comes.
- Overconfidence Bias: Overconfidence bias is the investor’s hubris, a belief in their infallible market foresight, often birthed from past successes. In the glow of a bull market, it’s easy to feel like an investment savant, where every decision turns to gold. This bias can lead to riskier bets and a disregard for diversification, as investors start to attribute success to skill rather than market conditions or luck. Overconfidence tricks us into thinking we can outsmart the market, ignore fundamental analysis, or dismiss divergent views. When the market turns, overconfidence can result in a steep learning curve as the reality of randomness and uncertainty sets in.
- Recency Bias: Recency bias convinces us that what happened in the near past will continue into the future. During market highs, recent gains overshadow the memory of past losses, leading investors to project continuous growth. This bias is seductive; it simplifies complex market behaviors into recent trends that feel predictable and safe. In contrast, during a downturn, recent losses make it difficult to envision recovery, leading to despair and a knee-jerk reaction to sell. Investors caught in recency bias often miss the bigger picture, failing to see that markets are cyclical and what goes down often comes back up.
- Loss Aversion: Loss aversion is rooted in a primal instinct: the pain of loss is psychologically about twice as powerful as the pleasure of gain. During bear markets, this fear can become paralyzing. The potential of losing hard-earned money can lead to panic selling at the worst possible time, locking in losses instead of weathering the storm. Conversely, during bull markets, the fear of losing unrealized gains can cause investors to cash out too early, missing out on greater profits. Effective investment strategy often requires counteracting this instinctual bias by making decisions based on long-term potential rather than short-term fluctuations.
- Anchoring Bias: Anchoring bias causes us to rely too heavily on the first piece of information we see – often a past high or low. In bull markets, investors anchor to peak prices and hold out for their return, sometimes leading to holding declining assets for too long. Conversely, in bear markets, they anchor to recent lows, selling off assets in fear of further loss. This bias can impede our ability to adapt to new information, skewing our perspective on an asset’s true value. Overcoming anchoring requires an awareness of this tendency and a commitment to continuously reevaluating our investments in light of new data and broader market trends.
- Confirmation Bias: Confirmation bias is our tendency to seek out, interpret, and remember information that confirms our preconceptions. In a bull market, this might mean overemphasizing positive news or data points that suggest continued growth, while discounting information that signals a potential downturn. In a bear market, the opposite happens; investors may focus on negative indicators and ignore signs of an upswing. This bias can lead to missed opportunities or unwarranted pessimism. Combating confirmation bias requires a deliberate effort to consider contradictory evidence and maintain a balanced view of the market’s potential risks and rewards.
The Bonus Insights: Greed and the Fear of Selling
As I reflected on the recent market madness, another aspect emerged: greed. It doesn’t discriminate, and even governments, once resistant, may soon pivot when they smell the lucrative scent of taxation in the crypto realm.
Then there’s the fear of selling – akin to a fear of winning. It's the anxiety that comes with making a move, the dread of premature action, or the regret of missed gains. This fear can be as paralyzing as any loss, as confounding as any dip.
In the thrall of these biases, my advice stands clear: have a plan. I have a plan or code when I walk into a casino. I have a $200. If I lose it, I leave. If I double it, I leave. A strategy helps navigate the unpredictable tides of investment. Set buy and sell thresholds, and adhere to them with the discipline of a chess grandmaster or a disciplined quarterback marching down the field.
Remember, these are but ripples in the ocean. Whether you've witnessed the dot-com era, the mortgage meltdown, or the crypto winter, the pattern is unmistakable – life is cyclical. The real victor is the one who plays the long game, who sees beyond the immediate to the horizon where new opportunities await.
Excerpt: "The ability to recognize that that life essentially is just a giant cycle. Ebbs and flows, life and death. Winter spring, summer and fall. Booms and busts, bulls and bears, a constant pendulum. It is so cyclical, seasonal, and rhythmic in nature, that is life. And the only way that you beat those highs and lows is by zooming out; the long game. The longer the longer you're in it, the more likely you are to win it."
