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Cryptocurrency and herding behaviour

Fertile soil and the herd that follows it.
Image: Chris Ratcliffe/Bloomberg

Recent studies suggest that cryptocurrency investors rely less on expert advice and increasingly follow peer investor communities for guidance.

The daily value of South African crypto trading recently exceeded $141 million for the first time, indicating that many South Africans consider the risks of this complex, unregulated market to be acceptable for the returns which it may deliver.

Digital advocates have hailed cryptocurrencies as the “new gang on the block, who refuse to play along with the traditional rules of engagement”.

For the first time, investors feel “freed” from the constraints of financial regulations and can find their own “facts”.

Given that many people find blockchain technology difficult to understand and struggle to explain the excessive volatility in the crypto markets, it is interesting that they rely mainly on online sources, such as social media and social news aggregation websites, to shape their cryptocurrency investment strategies.

The abundance of information from like-minded investors has heralded an era of information-enabled investors. For the first time, the early adopters of blockchain technology and cryptocurrency understood the underlying opportunities and trends better than their knowledgeable financial advisors.

Its value, in essence, is determined by its unique characteristics and similar opinions.

One of the foundations of behavioural economics is the principle that under conditions of uncertainty, complexity and time pressure, people tend to revert to cognitive shortcuts or mental biases.

This, and the growth in popularity of cryptocurrencies, plus an abundance of available information, is driven by something called the network effect. The network effect implies that the more people who participate, the higher the crypto value becomes.

The second factor that plays a role in shaping the price of cryptocurrency is called social judgement.

Social judgement theory states that you accept or reject a statement on your cognitive map. Having already been primed to the opportunity of cryptocurrency by the network effect, “whales” – early adopters in the crypto world – who have amassed vast crypto investments have the power to artificially create exaggerated price swings or speculative bubbles. ‘Crypto Celebrities’ make a proclamation, and vast numbers of followers follow suit.

This sort of volatility concerns institutional financial minds and scares some investors off but equally attracts large volumes of new trade after some off-the-cuff announcements on social media platforms.

Fertile soil and the herd that follows it

The market for cryptocurrencies seems to provide fertile soil for investor biases to steer decision-making. An obvious example would be the bandwagon effect whereby investors buy cryptos primarily because others are doing it, regardless of their convictions, which they often override or ignore.

A study by Calderon (2018) confirms that crypto investors display herding behaviour when navigating crypto market ambiguity. Investors tend to hold on to their cryptos, even in highly negative conditions, partly explaining the weak link between information and market outcomes. This is typical herd behaviour.

The downside of herds

The flipside of the potential gains to be made from crypto coins is the tendency for herd behaviour to create opportunities for exploitation.  South African crypto investors had to stomach two of the largest crypto scams in the world this year. In January, Mirror Trading International disappeared with about 23 000 digital coins, valued at $1.2 billion and in April, Africrypt allegedly absconded with about $4 billion worth of coins.

Although one could argue that the digital revolution has brought a new level of empowerment to consumers, it seems that it has also intensified people’s judgement biases.

There are no real reference points to determine the value of crypto-currencies, and therefore the pricing mechanisms are driven mainly by collective evaluation of the buyers and sellers.

People tend to jump on the bandwagon and mimic the behaviour of others, often on the basis of anecdotal evidence of success stories on social media, without fully appreciating that the human tendency to herd under conditions of optimism or positive news creating market bubbles and crashes.

There is, admittedly, a range of examples in the traditional financial markets where herding behaviour also drives the decisions of many investors. The difference, though, as many South Africans now can attest, is the inherent risks of an unregulated, complex market where “coin-diggers” – those wishing to make a quick buck – can, and do, capitalise on the flaws in human decision-making nature.

Udette Kirsch is a behavioural economist and strategic marketing specialist.

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If you have a lot of money and nothing to do with it, fine, gamble on Crypto. But I cannot for the life of me shake the immage of the gambler at a roulette table. There is no way of knowing the outcome, but the nature of the gambler is the compulsion that drives it. The best advice I’ve seen on MW holds true: don’t invest more than you’re prepared to lose.

Interesting comment. Agree that some comes can be compared to gambling, but others definitely not. For example have a look at BTC price growth the past 13 years (it is clearly heading north succeeding all doom profits predictions, surviving all sorts of onslaughts, etc. ETH’s has real value as its network has practical applications.

My recommendation to you is to invest in these 2 coins, past history and future potential/use are what makes this not a gamble.

Interesting that you’d mention 13 years. Crypto is often compared to the early days of the internet, but any technology worth its salt, say email, doesn’t take 13 years (and counting) to become widely adopted. There are fundamental technical and economic reasons why both blockchain and crypto have gone nowhere in terms of practical usage in 13 years.

Any investment is a gamble and the number one rule in gambling is big risks = big rewards.

If you believe that giving your money to a man in a suit in a fancy building means your investment is safe and guaranteed you are very naive.

At least there are some rules and you may have a comeback if you put your money into, say, VBS. Even VBS depositors got their money back, in spite of the bank being robbed. Crypto was however designed to evade the authorities and to aid and abet illegality. MTI’s gamblers can therefore forget about ever seeing their crypto again. This is the problem: the market makers in crypto may wear suits, but so did the Mafia.

55 of the world’s top 100 banks by market cap are invested in btc and blockchain. Is there something they know that we don’t? Herd behavior happens to others asset classes.

Not a good example, banks. Most US banks were heavily invested into subprime mortgages prior to 2008.

Bitcoin ETH upside is limited but still important for crypto growth and attracting capital.

However, if users are able to open a voyager or coinbase account, the following coins will buy the beach house (diversify always).

Luna (terra)
Decentraland
Polkadot
VeChain
Orion

Spread your risk and at least one will be a winner although Luna’s fundamentals are the most impressive.

End of comments.

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