14 Common Cognitive Biases That Crypto Traders Need to Avoid

Author: The DeFi Edge

Compiled by: Gu Yu, Chain Catcher

To become a better crypto investor, I studied hundreds of cognitive biases. Here are the 14 most important ones:

1) Unit Bias

People prefer to buy "whole units" of tokens rather than a fraction of one. This is why meme tokens exploded. Don't overvalue a token just because it's "cheap." Understand how market capitalization works.

2) Anchoring Bias

Over-relying on the first piece of information you have. You heard about Bitcoin at $1,000. You missed it. Then it rises to $5,000. You don't want to buy anymore. It's "too expensive" in your mind. Evaluate it based on its potential, not its past.

3) Confirmation Bias

You only want to see the news you want to see. You only focus on those who speak positively about token X. You unfollow and block anyone spreading "FUD." When you invest, look for and research FUD to see if it holds any validity.

4) Sunk Cost Fallacy

Costs that have already occurred and cannot be recovered. We tend to keep putting more money or over-investing because we fear losing our initial investment.

5) Loss Aversion

Losing money feels worse than making money. Anyone who has been to Las Vegas knows what I'm talking about. The feeling of winning $100 is different from losing $100. Losses are painful. One study shows that the brain typically assigns 2.5 times the weight to losses. +$250 = -$100

For example, when your investment drops by 50% and there’s more bad news. You could close the trade and minimize your losses. Loss aversion means some people would rather wait it out. They fear "losing" money by selling.

Loss aversion leads to risk aversion. There have already been some scams in DeFi, and I've seen some people swear off investing in DeFi again! Their losses mean they will miss out on life-changing gains. Weigh risks and rewards correctly.

6) Recency Bias

We overestimate recent information and events. "ETH's price is boring. I want to chase low market cap tokens," and then they get wrecked in a bear market. You can overcome recency bias by zooming out on the charts.

7) Overconfidence Bias

We overestimate our abilities. We have a few lucky breaks and think we are smarter than we actually are. The key to overcoming overconfidence is having a reliable risk management strategy.

8) Endowment Effect

You develop an emotional attachment to your portfolio. We assign higher value to investments because we own them. I've seen a lot of this with ETH maximalists. They’ve made huge gains and become emotionally attached. They ignore all other L1s.

How to overcome the endowment effect with zero-based decision-making. "If I didn't own this investment, would I invest in it today?" This makes your decisions more neutral.

9) Survivor Bias

Brad Pitt moved to Los Angeles and was a waiter before becoming a movie star. Many people follow his path hoping to do the same. You don’t hear about the thousands of others who tried the same and failed.

Someone turned $8,000 into $5.7 billion with Shiba Inu. You won’t hear about the thousands who turned $8,000 into $500. The media prefers to report on winners, which distorts your perception of the odds.

10) Narrative Bias

Human love stories help us understand the world. Some tokens explode because of their story. Remember last year's GameStop? It was a revolution against Wall Street. People invest based on narratives.

11) Herding Bias

Investors tend to follow and replicate the actions of other investors. They are largely influenced by emotions and instincts rather than their own independent analysis. If you've ever felt FOMO, it might be due to herding bias.

12) Availability Bias

You make judgments based on how easily you can recall information. After a major plane crash, people often fear flying. However, 1 in 9,821 die in a plane crash, while 1 in 114 die in a car accident. In reality, flying is safer.

In crypto, availability bias appears in marketing. A token might get pumped because it has good marketing. Marketing is important, but make sure it doesn't overshadow a bad project.

13) Outcome Bias

Outcome bias is the error of evaluating the quality of a decision based on its known outcome. Imagine going all-in with AA against JJ in poker (where AA has an 80% chance of winning) and then losing. You made a great decision, but the outcome was bad. You invested $10,000 in a shitcoin, and now it’s worth $100,000. That’s a good outcome, but it was a bad decision.

Another angle on outcome bias is to imagine if the scenario were replayed a thousand times. You have to consider the differences. You can do everything right, and the outcome still won’t be right. That’s life. But you should always make decisions based on the best odds and probabilities.

14) Authority Bias

This is our natural tendency to follow leaders. Once we believe someone is an expert, we tend to believe everything they say.

How do you stop cognitive biases? Here are some strategies I use to mitigate the damage of cognitive biases.

• Create a cognitive bias checklist. Whenever I make an investment decision, I refer to my cognitive bias checklist. This makes me aware of my thinking flaws.
• Consider creating your own investment system. Formulas can help you control emotions.
• Keep a trading journal. I maintain a Google spreadsheet that contains all my trades. Besides financial data, I also write down some of my arguments. If I exit early, I note any issues I encountered. By the way, I plan to create a free template for you.
• Leverage cognitive biases to your advantage. Understanding cognitive biases means you can profit from others. A token with a good narrative + a charismatic leader + marketing (availability bias) + herding behavior. The more idolized, the more likely to profit.