The Biggest Reason Why People Lose Money In Stock Markets And Cryptocurrencies

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Includes: BTC-USD, COIN, GBTC
by: Ruzbeh Bacha

We humans are social creatures by nature. Our banding together and sharing of information has catapulted us from cavemen to spacefarers in just a few millennia. Society and human contact are essential to our success. But, as with anything, there are pros and cons to the social nature of people. Due to this social involvement, we often compare ourselves to our peers. It is better to be impoverished among the impoverished than it is to be just above the poverty line but among the rich. Practically, it means the cost of living is higher, but psychologically, it can be devastating to see others doing well and yourself failing - or at least, failing relative to your peers.

In our age of social media, others' high points are always on display and their low points are hidden. At the turn of the millennium, dot-com millionaires demonstrated that we, too, can become rich by choosing the right investments. In the 2000s, house flippers showed us that we too can become rich by finding the right properties. In the 2010s, Bitcoin millionaires have refreshed our memories of this phenomenon and made us wonder if this is a smart investment. However, were those investments logical investments or gambles? Even if reason suggests we avoid an investment due to overvaluation or extremely high risk, we gamble anyway. After all, if everyone else is correct, we get left behind. No one wants to be a thousandaire, living paycheck to paycheck when old friends and colleagues are enjoying their new Ferraris and private yachts.

The Traditional Approach to Finance

Using traditional economics and finance, we should see a market full of rational investors making rational decisions and avoiding overly risky situations. Using calculations, history, and due diligence, investors should be wary of any skyrocketing asset. Warren Buffett famously stated: "Be fearful when others are greedy and greedy when others are fearful". See some other quotes from smart investors here.

Finance classes tout the rationality and efficiency of the markets to agree on appropriate prices. But do the mechanical ideas of the efficient market always trump the irrationality of investor psychology? The adage "The markets can remain irrational longer than you can remain solvent" seems to say "no". If strongly efficient markets do exist, they certainly disappear during a bubble.

One driver of behavioural finance is FOMO - Fear of Missing Out. Another is an expectation that the current euphoria will continue. We have seen this now and in the past in the stock markets, cryptocurrencies, real estate, and other risk markets. The mainstream media covers the events constantly, social media feeds are jammed with stories of success, and prices just keep rising. If you don't get in now, you will be left behind.

The "Can't Lose" Bull Market

In the late 1990s, the Internet was capturing the public imagination. This revolutionary technology would change the world, and cashing in on the revolution was easy. Simply change your business to an online model and, even without revenue or a solid business plan, investors would pour money into your IPO. It was a grand bull market until the supply exceeded demand and the bubble burst.

In the 2000s, the barrier to owning your own home was low. In the United States, especially, large loans became accessible even for no-income individuals. It seemed home prices would continue rising no matter what. From 1975 until the mid-2000s, this was true. 30 years of data should be sufficient to establish a trend, right? Layman arguments for this trend included increasing population, more wealth overall, and the scarcity of real estate. If you bought property, you were bound to make a profit - don't worry about those pesky interest rate increases in the terms of your mortgage, you can just sell the home for a tidy profit and move into something that fits within your budget. Until prices stopped rising and the whole market collapsed, sparking the 2008 Financial Crisis.

Since the explosion of cryptocurrencies into the public consciousness, literally hundreds of coins and tokens have been issued. 2017 witnessed endless ICOs, many companies that do not truly rely on blockchain technology. Despite major corrections, all of the influential cryptocurrencies are worth more now in January 2018 than they were in January 2017. Much, much more in most cases. Many coins have a working technology, but others have placed their base technology development in the future on their roadmaps. It seems a bit like the no-revenue, domain-only companies of the dot-com bubble. But why not buy a few cryptos? They're the way of the future, they're bound to increase in value, there's nothing to stop them. Until a superior technology emerges or governments start to crack down on unreported profits and ownership.

Fear of Falling Behind

In early October 2007, two Stanford University researchers claimed: "what investors fear the most is not the risk of a loss per se, but the risk that they may do poorly relative to their peers". It was found that external factors are important, and a mechanical, rational, automaton-like motive of profit maximization is not the only metric for the living, breathing investors. As we wrote above, no one wants to fall too far behind. But there is also a survival mechanism involved: if the prices of everything rise in your neighbourhood, you will be forced out.

In fact, the researchers found that investors will crowd into overpriced assets, even if they know they're overpriced. The fear of diverging from the group is so strong that investors act irrationally, at least from the perspective of traditional financial models. As more money floods into the asset, the ones on the outside see the rapidly rising portfolios of peers and also jump in. So it seems that as those who stay outside are left further and further behind, the social pressure to join the phenomenon increases.

The Stanford researchers also found that high-tech stocks are particularly susceptible to this type of speculative bubble. Since new technologies are, by definition, new, it can be very difficult to gauge their true value to society - people may inflate their worth as they rationalize their irrational investment decisions. And companies are prone to this issue, too. The Stanford article mentions telecoms that rushed into laying fibre optic infrastructure, but its use was far overestimated, and significant amounts of cable still lie dormant, 20 years after its installation. The supply skyrocketed, eventually causing the price to plummet (i.e., the fibre optic bubble burst).

In our recent broker predictions article, we saw that many brokers are cautiously approaching 2018 because equities and fixed income are both expensive. It seems everything is overvalued - but they expect prices to continue to increase. There is enough positive expectation that investors stay, and according to Reuters, investors fear missing out on the gains from those positive factors.

On one of the more controversial asset classes, cryptocurrencies, the naysayers are as loud as ever, especially as the market caps of many coins and tokens reach into the hundreds of millions and upward of hundreds of billions of USD. Greed abounds, and Warren Buffett is sticking by his own quote. This time, he says, FOMO is driving the greed.

The Social Media Amplifier

The Stanford article was published in 2007. This was before Facebook and other social media became integral to the lives of a large portion of the population. Today, FOMO is amplified in every area of life. Smartphone and social media addiction are widespread, and there is an emerging phenomenon of social media-induced depression. The idealized version of peers observed on social media convinces the viewers that they are leading less happy and productive lives. What is a logical way to becoming more fulfilled? Follow your peers. If an emerging technology seems promising, many people will be talking about it. Social media use spreads awareness rapidly, and it continuously injects updates on the technology and price into viewers' lives. If near-constant gains occur in a can't-lose bull market, it seems everyone is becoming rich except for you. This is precisely the fear that the Stanford researchers studied.

How to Avoid FOMO and Devastating Bubble Bursts

The best way to avoid a bubble is to never invest in a bubble in the first place; the second way is to invest early and get out early. Since the latter is significantly harder to achieve, let's focus on the first one.

Since FOMO is a major psychological problem for social media users, there is more and more psychology literature pertaining to the avoidance of FOMO. We can use those same techniques for avoiding rising bubbles in finance.

Dr. Aarti Gupta, a clinical director for an anxiety centre in California, suggests admitting you have a problem, turning off the constant influx of activity generated by others and practicing mindfulness. These are meant to cure FOMO in social media. If we adapt them to investing, the first would be to acknowledge you cannot invest in every asset. If you had unlimited time and money, then you wouldn't need to invest - but you don't, so don't think you can catch every market movement and every great new stock.

The second would mean removing yourself from constant feeds of others' opinions on the subject and the great lives others are enjoying courtesy of their grand investments. This could be limiting online contact, but as we saw from the Stanford researchers, many times we form portfolios similar to our peers at work - in that case, we suggest steering the conversation away from investments and into something else.

The last is practicing mindfulness, which is a bit like hyper-awareness or reverse meditation. It is focusing on the present, both temporally and spatially. Focus on your surroundings and engage in perceiving the feel of your clothing, the sounds produced by the HVAC system, the way the light reflects off your window. If that does not work, one of CityFalcon's tips includes meditation. Meditation, the lack of thought, is a good way to detach from the stresses of FOMO. If clearing your mind on demand is too difficult, we recommend a long, hot shower.

FOMO is a psychological response based on our social nature. We know that excessive bull markets are the last leg of a bubble, and smart money gets in early. However, most of us don't have the connections to be smart money, so our first contact with a revolutionary new technology is in the euphoria stage. Don't get sucked into the euphoria by way of FOMO.

In Summary

Irrational investments are irrational for a reason. Timing the markets is not easily accomplished, and powerful investment banks and AI hedge funds are far ahead of you in that endeavour. Unplug a bit, meditate and put your world in perspective. You really are missing out if you constantly indulge yourself in the lives of others - take a step back, enjoy life and make investments for the long term. Once you become rational again, invest your money in stable money makers. If you still need validation, know that with a stable incoming-producing portfolio, you are still better off than many others. The next time you decide to buy risky securities in the stock markets, cryptocurrencies or other markets, ask yourself - Am I buying because I believe in the underlying investment, or is it just FOMO?

And those Bitcoin millionaires? If they don't cash out soon, we don't think they'll be millionaires forever, anyway.

Disclosure: Author and stakeholders of CityFALCON may have vested interest in the financial securities discussed in the article.