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An investor thinks about bitcoin

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Whether you're talking Bitcoin, Ethereum, Litecoin or Ripple, it seems everyone has someone in their circle who will seize any opportunity to announce a record-breaking run on their cryptocurrency investment (or, as has been the case for parts of January, an inevitable slide).

It's impossible to scroll your social media feeds or be in any social setting without cryptocurrency coming up during the conversation. Those of us not investing in bitcoin usually come to the inevitable conclusion that we are somehow missing out and should be capitalizing on these seemingly impossible returns. Even the biggest skeptics feel a sting of regret when they hear about others who made upwards of 1,000 per cent or more on their cryptocurrency investment.

But whether you should or shouldn't invest in Bitcoin, or other cryptocurrencies, is a personal decision. As a behavioural economist, I can share some insight into the mental processes that influence our thinking around something like cryptocurrency, and how the public perception of it has dramatically shifted from an untraceable currency used by criminals on the dark web to a get-rich-quick opportunity in a matter of months. The cryptocurrency frenzy has less to do with intelligence, risk-tolerance or experience and more to do with human psychology. It's so deeply embedded in psychology that most dinner party conversations about it usually follow a predictable pattern.

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Let me see if I can guess how it unfolds:

"All the smart players are getting into cryptocurrency..."

One of the primary reasons everyone is investing in cryptocurrency is because, well, everyone is investing in cryptocurrency! This is explained by a foundational principle of psychology referred to as "herding": the phenomenon whereby individuals adopt the behaviours and beliefs of those around them without individual decision-making or thoughtfulness.

Don't pretend you haven't done this. If you've ever stepped off a curb after seeing someone else jaywalk, you've definitely fallen under the influence of herding. When we hear about people we know investing in cryptocurrency, it signals that it's the norm and makes us feel like we should follow suit.

Years of theoretical and empirical research by behavioural economists at the most prestigious institutions, including UCLA and Princeton, have identified herding as a primary cause of the biggest market bubbles in history. Analysis by stock market research firm Birinyi Associates late last year confirmed that cryptocurrency is on track to be one of the biggest bubbles in human history, with the price-to-earnings ratio of Bitcoin clocking in at four times the cost of dot-com stocks at their 1990s height.

Herding not only occurs because of an innate desire to be part of a group, but is also driven by two of the most powerful human emotions: fear and regret. Even those we regard as experts fall prey to the power of herding. A 2007 study by Peter DeMarzo, Ron Kaniel and Ilan Kremer out of Stanford University found that even when investors recognize an asset is overpriced and likely to burst, they frequently herd into risky investments for fear of diverging from the crowd and watching the price continue to rise. The researchers found that our greatest fear in investing isn't the risk of loss, but rather the risk that we will do worse than everyone else. It may not be surprising that the fear of being poor isn't nearly as great as the fear of being poor while everyone else is rich.

"There was this article I read that says cryptocurrency is here to stay..."

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It's only natural for people to leverage supporting "evidence" for their beliefs. This form of confirmation bias describes our tendency to search for, interpret or recall information in a way that reaffirms our actions or beliefs while discounting alternative possibilities. In a crafty 2009 experiment at Ohio State University, participants were asked about their interest in politics and subtly asked about their opinions on specific issues before browsing an online forum with articles supporting opposing views on the issues. Participants spent 36 per cent more time reading articles that supported their views.

Cryptocurrency investors gravitate to information about sky rocketing returns to validate their decision, while simultaneously ignoring information about price fluctuations, potential criminal implications, vulnerability to theft and a host of other reasons many retailers, financial institutions have yet to warm to cryptocurrencies.

Our brains are wired to identify patterns and form predictions about upcoming events. This often causes us to incorrectly see structure in random sequences and expect that the "patterns" will persist. This happens everyday in casinos with gamblers who are on a "lucky streak." It can also explain your favourite basketball player's "hot-hand" in last night's game. Recent research out of Duke University revealed that people perceive patterns after a sequence repeats as few as two times, influencing their expectations for future events. As the price of cryptocurrency continues to rise several weeks in a row, we can't help but interpret this as a trend and assume it will continue far into the future. Mind you, the same might be said for its nerve-wracking drop in January.

"I mean, sure these returns may not be sustainable, but I'll get out before it turns."

Just before your friend's conversation inevitably pivots to some other popular topic, such as the likelihood of a their own sports team being victorious, you start to get a sense of the well-established judgement and decision-making bias psychologists know as overconfidence. This occurs when a person's subjective faith in their judgments is significantly greater than the objective accuracy of those decisions.

Research has shown that financial experts may actually be more susceptible to exhibiting overconfidence and other related biases. James Montier's 2006 study "Behaving Badly" found that 74 per cent of 300 professional fund managers believed their job performance was above average, while the remaining 26 per cent rated themselves as average. The result was statistically impossible as 100 per cent of the group that viewed themselves as average or better. Many of these managers also thought they could influence the outcome of their investments (which is known as 'an illusion of control') and that they knew more than everyone else ('an illusion of knowledge'). When someone you know starts talking about cryptocurrencies using words like "certain" or "fail-safe" you can rest assured they are fooling themselves.

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So, the next time you find yourself getting into that all-too-familiar cryptocurrency conversation and you start to feel the itch to invest, look at the facts – all the facts – and decide if it's the right investment for you. If you have your financial bases covered – funds set aside to pay down your mortgage, service debt and save for retirement should probably be off limits – you might view a dip into cryptocurrency as a fun experiment. But if it's not the right decision for you and you can't stand to lose any investment, stick to your guns, even if it means changing the conversation to the latest news on Trump.

Stephanie Bank is a behavioural economist at Evree, a Toronto-based startup that builds software and tools to make saving as easy as spending. If you have a question you'd like answered, send it our way.

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