How behavior is contributing to the meteoric rise of cryptocurrencies
Mitchell Barr, Client Associate
In the movie Old School, Will Ferrell’s character is a middle-aged man named Frank who’s reliving his college glory days. My favorite scene is where Frank has a few too many beers at a college party and declares, “We’re going streaking through the quad to the gymnasium!” It turns out Frank was a little more eager than the rest of the party-goers because the scene ends with his wife picking him up on the side of the road running naked by himself. His defense, of course, was “Everybody’s doing it,” except he realizes that no one has joined him and actually he’s a little cold.
I don’t think any of us would strip down and start running through the streets naked by ourselves. But social pressure has a way of convincing us that it’s okay to do things we normally wouldn’t. This psychological phenomenon is known as herding. Instinctively, we want to be part of a group and often we are afraid of breaking from the pack. This behavior used to be a means of survival, but unfortunately it applies even when the behavior is not rational, which explains why sometimes investments that are exposed to the herding effect can exhibit spectacular rises, only to fall back to earth just as hard. Even entire markets can be affected, as was evidenced by the NASDAQ bubble during the turn of the century in 2000. Any company with “.com” in the name was being gobbled up by investors who were more than willing to blindly throw money into the stock.
The most recent example of the herding effect in action is Bitcoin and other cryptocurrencies. The meteoric rise in the price of Bitcoin has novice investors and professionals alike paying attention. In doing research for this article I was targeted by and advertisement telling me to rollover my IRA to Bitcoin. It’s everywhere. Many of you are probably asking, “Am I missing out on this?” If you want to discuss the efficacy of Bitcoin and cryptocurrencies in general, we can do that over a beer sometime. It’s much too complicated to address in a short blog post. But since behavior can often be irrational, whether or not Bitcoin is the real deal may be irrelevant to what will happen to the price in the near term.
When we look at the chart below, we see an asset that has exploded in value in a very short period of time. Coinciding with that explosion there have also been tremendous bouts of volatility in the price as indicated by the arrows. As recently as a few weeks ago there was about a 25% drop in the price of Bitcoin. This is very indicative of herding behavior, with investors predictably buying and selling as the price moves and amplifying the effect. In other words, speculation is driving the price.
Below is a chart of the Nasdaq composite index (^IXIC) from 1/1/1998 to 1/1/2002 to give you an idea of the resulting fallout of the tech bubble. You can imagine that investors who bought in with feelings of euphoria in March of 2000 weren’t smiling quite so brightly by the end of 2001. Like Will Ferrell in Old School, these investors were the poor souls that found themselves naked and alone in the cold when the party was over.
Source: Yahoo! Finance
I want to make it very clear that I have no idea if the Bitcoin story is going to end like the tech bubble. It could very well be different this time. But for every point of view there is a counterpoint. Your first impulse will always be to follow the herd, so it’s always a good idea to check that instinct by searching for alternative points of view. Find the one person who is screaming, “Hey idiot! It’s 40 degrees outside. Put your clothes back on.” They might just make you realize you don’t want to follow the herd after all.
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.
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