Lisa Kramer is a professor of finance at the University of Toronto. You can follow her on Twitter at @LisaKramer.
With the price of bitcoin and other cryptocurrencies plummeting, behavioural finance can help us understand both the lead-up to the digital currency craze and the way speculators are responding to their new-found losses.
Financial economists have been cautioning for months (and in my own case, years) that cryptocurrencies such as bitcoin were in the throes of a bubble. Not everyone heeded the warnings. There was rampant conflicting advice, making for confusion.
For example, when bitcoin first surged above US$16,000, cybersecurity pioneer John McAfee famously asserted that "bubbles are mathematically impossible in this new paradigm," adding that experts who urged caution were simply failing to understand the "new mathematics of the blockchain."
Well, there may have been some flaws in Mr. McAfee's calculations.
Cryptocurrencies arguably have no fundamental value, and so when the hype fades and alleged instances of fraud are uncovered, there is no basis for prices to stay at their stratospheric heights.
Investors staring at the sea of red on their balance sheets might take some lessons from behavioural finance.
First, investors in all kinds of assets tend to exhibit what's known as the disposition effect.
They hold onto securities that have performed poorly, in hopes that their prices will rebound upward, and they sell those that have performed well.
The cryptocurrency community has unwittingly bought wholeheartedly into this bias, coining their own label to encourage and exaggerate the tendency to hold onto losing investments: HODL, meaning "to stay invested in bitcoin and not to capitulate in the face of plunging prices," according to the digital news outlet Quartz.
Strong forces of human nature underlie the HODL approach, making it hard to overcome.
The biggest factor is likely loss aversion, the notion that losing a dollar hurts at least twice as much as gaining a dollar feels good.
And, related to this point, it is perhaps easier not to consider a dollar "lost" until a poorly performing security is actually sold; somehow continuing to hold onto a paper loss hurts relatively less than actually selling a loser security because the investor can continue to hope she will regain her losses.
Another contributing factor behind HODL is the sunk cost fallacy, which can cause investors to toss in good money after bad.
Strong human tendencies such as these help us understand why people are continuing to hold onto their waning cryptocurrency balances, or are even doubling down on their wagers, and are hoping against hope that the high prices will return.
This is not the path to financial freedom. Research on discount brokerage accounts shows that investors are on average better off doing the opposite of what the disposition effect entails, instead selling the individual loser securities and holding onto the winners. But it is tough to go against human nature.
(And the best approach of all, of course, is to buy and hold a diversified portfolio, ignoring market ups and downs.)
Confirmation bias is a factor that contributes to the rise of financial fads in the first place. People tend to seek out only that information that aligns with what they already believe to be true.
In cryptocurrency circles, believers congregate in chat rooms and other echo chambers where naysayers are ridiculed and promotional news stories are celebrated, to the exclusion of critical analysis.
Closely related, overconfidence plays a role as well. Many who invested in cryptocurrencies vastly overestimated their own financial prowess, a phenomenon that will be familiar to anyone who remembers taxi drivers quitting their jobs in the late 1990s to become day traders.
So what is a fretting cryptocurrency speculator to do? Above all, remember that to make mistakes is to be human. And then take the next step, which too few seem willing to do: Learn from your mistakes and strive not to repeat them.