Beat Bitcoin’s 800% 1-Year Returns: An Economist's Perspective
Part 1: WHY MOST people fail
The number of people showing interest in Bitcoin and alternative digital assets is growing at an increasingly exponential rate. Some of these people may believe in the fundamentals behind the technology, while others just want to ride the wave of these mammoth sized returns. Then why are most people not making the returns that Bitcoin has achieved this year? How can you maximize your chances of making these gains, or even better, make better gains than the market leader, Bitcoin?
Before I get into this any further, I would like to provide some context as to where I am coming from. I am an undergraduate economist by training at UC Berkeley with a focus on Finance and Behavioral Economics. I am by no means, an experienced trader, but what I can provide you with are experimentally proven reasons that are holding most people back from making money in this market.
Economics, at least till the level that most people learn up to, assumes that humans are rational probability weighted utility maximizers. This very limited Intro to Macro Econ perspective is held by even college educated people and troublesomely, by our elected policy makers as well.
Let’s put this in simple words in the context of trading. Consider the following trade: 50% Chance of losing $100 or 50% chance of making $110. Standard Economic Theory would dictate, that most people would take this trade because the expected gain would be $5. (0.50*$110-0.5*$100= $5 gain). Not surprisingly, when presented this option, most people did not opt for this trade. Because guess what? NO ONE acts rationally.
At this point, you might be thinking, why am I even reading this, I already have the common sense of knowing that humans are not rational. Most people may think that they are aware of this fact, yet when the time comes, in the heat of the moment, suddenly they forget their biases, they completely ignore the fact that they must fight against our innately irrational choices and make the decision which maximizes return.
More experienced traders might argue that the risk to reward ratio is only 1.1 : 1 (potential gain: potential loss), and hence it is sensible to avoid this trade if you are risk averse. (You value not losing money more than you value making money). This is where things start to get interesting. This idea gets debunked by research conducted on decision making in both professional trading firms and amateur solo traders.
The number of people showing interest in Bitcoin and alternative digital assets is growing at an increasingly exponential rate. Some of these people may believe in the fundamentals behind the technology, while others just want to ride the wave of these mammoth sized returns. Then why are most people not making the returns that Bitcoin has achieved this year? How can you maximize your chances of making these gains, or even better, make better gains than the market leader, Bitcoin?
Before I get into this any further, I would like to provide some context as to where I am coming from. I am an undergraduate economist by training at UC Berkeley with a focus on Finance and Behavioral Economics. I am by no means, an experienced trader, but what I can provide you with are experimentally proven reasons that are holding most people back from making money in this market.
Economics, at least till the level that most people learn up to, assumes that humans are rational probability weighted utility maximizers. This very limited Intro to Macro Econ perspective is held by even college educated people and troublesomely, by our elected policy makers as well.
Let’s put this in simple words in the context of trading. Consider the following trade: 50% Chance of losing $100 or 50% chance of making $110. Standard Economic Theory would dictate, that most people would take this trade because the expected gain would be $5. (0.50*$110-0.5*$100= $5 gain). Not surprisingly, when presented this option, most people did not opt for this trade. Because guess what? NO ONE acts rationally.
At this point, you might be thinking, why am I even reading this, I already have the common sense of knowing that humans are not rational. Most people may think that they are aware of this fact, yet when the time comes, in the heat of the moment, suddenly they forget their biases, they completely ignore the fact that they must fight against our innately irrational choices and make the decision which maximizes return.
More experienced traders might argue that the risk to reward ratio is only 1.1 : 1 (potential gain: potential loss), and hence it is sensible to avoid this trade if you are risk averse. (You value not losing money more than you value making money). This is where things start to get interesting. This idea gets debunked by research conducted on decision making in both professional trading firms and amateur solo traders.
Comment:
I like Prospect Theory because unlike most economics, this theory evolves from research done on real human beings, rather than the mystical rational person that most of economics has conveniently continued to model.
To clarify further, this is not a critique of people who hold long term investment holdings. I am a long term investor for most part as well, and in the future I will post how you can balance your portfolio in ways which minimize risk. What I am critiquing are the traders who simply jump from trader to investor and investors who jump into a trading role. When you do this, not only do you increase loses on the losers, but you also decrease gains on the winners! Compounded, this can and DOES drastically reduce your returns.
This irrational behavior is seen less in professional trading firms and more in amateurs. Its less to do with their skill but more to do with the STRICT RULES that you must obey at these firms. Heck, you could make your firm 20% on a trade but if it violates the rules you were supposed to follow, you would be in serious trouble.
To clarify further, this is not a critique of people who hold long term investment holdings. I am a long term investor for most part as well, and in the future I will post how you can balance your portfolio in ways which minimize risk. What I am critiquing are the traders who simply jump from trader to investor and investors who jump into a trading role. When you do this, not only do you increase loses on the losers, but you also decrease gains on the winners! Compounded, this can and DOES drastically reduce your returns.
This irrational behavior is seen less in professional trading firms and more in amateurs. Its less to do with their skill but more to do with the STRICT RULES that you must obey at these firms. Heck, you could make your firm 20% on a trade but if it violates the rules you were supposed to follow, you would be in serious trouble.
Comment:
This turned out to be a rather long read so I will end on this note. I haven’t forgotten that the title promises how you CAN beat the market, and I will be writing a follow up for this by the end of this weekend with the exact rules that are necessary for success. The trader I follow on this forum and hold a lot of respect for is @SEAN_VENGAN. Likewise, the investor I respect the most on this forum is @goldbug1. You will notice one thing which distinguishes them from the herd, both have a set of clear predefined rules. That takes a lot of discipline and should be what most people should focus on rather than charting advanced harmonic patterns without the slightest clue of risk management ;)
It turns out, according to Prospect Theory, that people overvalue events which have a low probability, and undervalue events with high probability. In our example, if down 10% on a trade, if there is a 10% chance of a rebound to breakeven, you might in your head consider that to be a 40% chance, hence making a losing choice of “HODL”. Similarly, if there is a 60% chance of making noticeably more money on a winning trade, you might in your head consider that there is only a 30% chance of more gains, and cash out.