The #Bitcoin Bubble Is Caused By The Halo Effect

One of the causes of the Bitcoin bubble is a cognitive bias known as the Halo Effect. I will explain how this works and how it is going to prove very expensive for holders of Bitcoin

The Halo Effect occurs when people judge the overall quality of an item or person by considering only a single property of that item.  This can lead to dramatic errors; most obviously when all of the other qualities of the item  are negative or highly questionable.  This I will argue here is one causal factor among several which have caused novice investors to buy Bitcoin.  When it crashes, they will lose all of their money.  They will be unable to exit the market because the power of the cognitive bias is too strong.

In this post, I will briefly set out the cognitive biases which are in play here before describing the Halo Effect and how it is another feature of human psychology which leads people to mistakenly buy Bitcoin.

The Halo Effect is not the only causal factor operative among the novice investors who are buying Bitcoin.  I have already argued:

— that another causal element is that Bitcoin buyers prefer their own experiences to any consideration of statistical data.

In addition, Bitcoin buyers share with Trump voters a distrust of experts, as I argued here:

We can see that as a two variants of the Dunning Kruger effect.  Here, people who lack competence are unable to detect such lack of competence. This makes intuitive sense since people who lack competence and are aware of it would presumably either take steps to address that lack or avoid activity requiring the relevant competence.

A corollary of that is seen in another variant of the Dunning Kruger effect: people are unable to detect true expertise.  We can see this when:

— someone is able to publish a book on Bitcoin when it is quite apparent that they do not have even a basic understanding of it.  For readers of this book, it must be impossible to recognise and benefit from well sourced, properly constructed arguments, for example in the mainstream media.

I turn now to the Halo Effect.  This was first seen in data about personality assessment in the military.  It was found that officers asked to rate their subordinates would in fact rely on a single criterion, and then assume that all other  relevant factors were correlated with that one criterion.  This is obviously dramatically false unless all of the other variables are correlated with the one assessed.  And that is highly unlikely to be true.

Many people are unable to distinguish Bitcoin from the blockchain.  This leads many of the novice investors who are buying Bitcoin to fail to distinguish between the two claims “I am buying Bitcoin” and “I am investing in blockchain technology.”

The blockchain is a distributed ledger system which offers transparent recording of transactions (or any data) without the backing of any central authority.  It is an extremely interesting technology which holds great promise.  It could, for example, be used to create corruption-resistant property ledgers.  That would be of great benefit, not least in combatting money laundering.

Bitcoin is termed a “cryptocurrency” even though it does not fulfil the roles of a currency in that it is not readily convertible and it is not a stable store of value.  It is used to reward the miners who maintain the blockchain on a widely dispersed set of servers.  However, it is clear that the blockchain and Bitcoin are not identical.

An objection has been attempted here by a Bitcoin proponent that it is not possible to have a blockchain without a cryptocurrency.  There are a number of readings of that, but on the obvious two, the claim is either false, or true but misleading.  If the claim is read as “you cannot run blockchain code without also generating a cryptocurrency” then it is false.  There is no reason why the blockchain code could not be run with the cryptocurrency elements redacted.

If the claim is read as “it is necessary to compensate the miners, ” then it is true.   However, the miners could be paid in $.  Or the blockchain could run in the cloud, or in many clouds.  That would carry some costs, but this is not a problem.  It would even be possible to compensate the miners in a cryptocurrency which was pegged against the $.  There is no need for the cryptocurrency to appreciate and definitely not to gyrate wildly.  I therefore conclude that the objection fails.

There is one positive property that Bitcoin possesses.  It is true that it is generated using the blockchain technology.  It is also true that the blockchain technology is extremely interesting, and being pursued widely by a number of serious players.  By contrast, no professional, experienced or institutional investor is holding Bitcoin.  Novice investors fall prey to the Halo Effect when they think that the one positive quality of Bitcoin is a measure of its overall quality, when in fact it has no other redeeming features at all.  This will prove to be a very expensive cognitive bias when the Bitcoin crash comes.

I discuss the effects of cognitive biases like the Halo Effect on financial market participants in my new book:

The Forthcoming #Bitcoin Crash Will Kill The #Trump Demographic

One common feature shared by both groups is distrust of experts

We know that if you voted for Trump, you are more likely to be less intelligent, less educated, poorer and more rural.  I will argue that this leads to a further feature — distrust of experts — which is required to be a supported of either Trump or Bitcoin.  This suggests that when Bitcoin crashes, Trump voters will experience most of the losses.  In this post, I will consider only the distrust of experts feature.

Note that I said “more likely to be []…”  We are talking about two curves here.  It is not certain that you are less intelligent and poorer etc.  It would not be an objection here to say “I have a PhD and I am rich and I voted for Trump.”  To say that would be to commit the Anecdotal Fallacy, which I argued yesterday:

— is also a major feature of the Bitcoin bubble.

One of the notable points about Bitcoin is that there are no professional, experienced or institutional investors who have invested in Bitcoin.  (If that changes, we should all become seriously concerned.). Everyone who holds Bitcoin is an inexperienced amateur.  I put this to a Bitcoin enthusiast, and received the following reply.

Mark Cuban invested big into Unikorn. Peter Thiel invested into bitpay which is a wallet company. Mike Novogratz (former president of fortress investments and partner at Goldman Sachs) runs Galaxy Investments (almost exclusively crypto). Tim Draper bought 30,000 btc in 2014.  And Bill Gates: there are no definitive articles on how much BTC he holds but he has plenty of quotes talking about how it’s the future

I will now show why none of that works.

Mark Cuban and Unikorn

The first point to make here is that it is odd to cite Cuban here since he is on record as saying that Bitcoin is a bubble.  The other problem is that Unikoin, the token involved in this ICO, is not Bitcoin.  (I also believe that almost all of the other ICOs are fraudulent, but I would need a lot more space and time to show that.)  Finally, Unikoin will apparently permit sports betting, so while I do not recommend that, it at least has a theoretical source of value.  Bitcoin does not.

Novogratz and Galaxy Investments

Novogratz and Galaxy Investment Partners have invested into the huge and under the radar Worldwide Asset eXchange (WAX).  This is like selling shovels to miners in the Klondike gold rush.  (Reportedly, Trump’s grandfather ran a Klondike brothel.)  Selling shovels is a great business to be in, irrespective of how many of the miners or Bitcoin holders go bust.  So this again is not an example of a major investor holding Bitcoin.

Tim Draper and 30,000 btc

This is the only one of the examples which approaches being serious.  We must take it seriously because Draper reportedly invested serious money: $18m.  And he is actually holding Bitcoin as opposed to backing exchanges.  The caveats though are manifold.  First, he lost 40,000 Bitcoin in the Mt Gox fraud, and the fact that this did not give him pause makes me think he is an esoteric thinker.  Secondly, a lot of his remarks concern enthusiasm “for the technology”.  It is very important to keep a clear distinction between Bitcoin — a Ponzi scheme — and the block chain — a very interesting technology.  Thirdly, this is one man against every investment bank, hedge fund, regulator and all the other expert investors in the world.

I have in fact been told that my 20 year experience of successful investing is a disadvantage, because it means I am unable to understand the “glorious opportunity” allegedly represented by Bitcoin.  There are in fact some advantages to disadvantages, as I argue in my new book:

— but that isn’t one of them.

Bill Gates and the future

This is an excellent example of muddled analysis and poor understanding of the importance of precision and sourcing one’s quotes from reputable sources.  (It is no coincidence that Bitcoin supporters and Trump voters alike disparage proper news sources like the New York Times and prefer websites with manufactured quotes.)  We are not actually given a quote from Gates which is the first problem.  But secondly, it is highly likely that Gates thinks the blockchain is the (part of) the future and is not holding any sizeable numbers of Bitcoin.  A distributed transparent ledger, which is what the blockchain is, is indeed a highly interesting piece of technology which would have many very useful applications.  As just one example, imagine replacing property registers with blockchain.  Myriad opportunities for money laundering and corruption would disappear, and be replaced with an efficient technology. The fact that Bitcoin is also built on the blockchain is irrelevant.

People in this country have had enough of experts

This is actually a quotation from a pro-Brexit politician, but we see the same pattern across the Brexit “debate,” in Trump vs Clinton, in global warming and in MMR Vaccine/autism.  In each case, you need to believe that you are right and anyone educated or with specialist knowledge is wrong.  You also need to believe that those people are lying to you — for no obvious reason.

The quality of the arguments raised by Bitcoin proponents can be seen to be extremely poor.  I discussed here:

— some really bad arguments.  What is remarkable here though is not the quality of the arguments — they are all very poor — but that this is someone who has somehow managed to publish a book on Bitcoin while clearly not understanding it at all.

So now you can decide.  If you invest in Bitcoin, you are lining up with the people who mistrust experts.  If you voted Trump, you did the same thing, because you are probably a climate change denier.  So I think there is a very strong likelihood that many Trump voters are also holding Bitcoin.  And they are going to pay a heavy price for both decisions.



The #Anecdotal Fallacy And The #Bitcoin Bubble

The Anecdotal Fallacy, wherein people privilege their own experience over statistics, is one of the many cognitive biases that infect our thinking. It is particularly dangerous in financial markets, as illustrated by the current bubble in Bitcoin

The Anecdotal Fallacy occurs when people ignore statistics and quote a story of events that happened to them.  Often, it will turn out not to have even happened to them, but to “someone they know.”  While this latter step is an additional move away from constituting useful data, it is not the most malign effect of this bias.  The main problem is that assessing probabilities on the basis of personal experiences is almost completely useless even when those personal experiences actually occurred.

There is only one way to assess probabilities, and that is to use statistics of similar event frequencies.  This is extremely hard.  In fact, even understanding it when it has been competently done by scientists or statisticians is extremely hard.  It needs a lot of training and it seems as though our psychology is almost designed to trip us up.

The Anecdotal Fallacy is extraordinary widespread.  It’s use seems in many circumstances to be almost automatic.  If you give anyone any data on anything at all, people will generally respond with what they think is a counterargument from their own experience.  Apparently intelligent and successful people fall into this error, so those qualities are not a prophylactic here.  For example, Rupert Murdoch recently tweeted a photo accompanied by the text: “Just flying over N Atlantic 300 miles of ice. Global warming!”

This is a fairly extreme example which may have been deliberately provocative, but in my view it is just quite stupid.  The ideas that global warming has to have happened already in all locations and that it would eliminate all ice on the planet betray a non-existent understanding of the problem.  The only way to assess the probability that global warming is a genuine threat is to look at graphs showing correlations between greenhouse gas concentrations and temperature rises over several decades.*  A personal experience is simply irrelevant to that task.

We also tend to over-estimate the probability of vivid events.  I see this as an aspect of the Availability Heuristic, which I think is related to the Anecdotal Fallacy.  We use the Availability Heuristic when we assess the probability of events by considering how difficult it is to think of an example of that type of event.  Obviously we will make systematic errors in probability judgment if some events are easier to recall than others, and more vivid events are more easy to recall.  I discuss this aspect of our psychology in the context of financial markets in my new book:


Why is the Anecdotal Fallacy relevant to the Bitcoin bubble?

Because everyone who is buying Bitcoin is doing so based on one of two events.  Either they themselves have recently made a large amount of money from buying it or someone they know has.  Twitter is full of stories of people doing so.  This is extremely vivid and alluring.  It draws more people in, which of course is what helps to sustain the bubble and indeed any Ponzi scheme.

Note that the problem is not that these stories are false.  A lot of people have indeed made a lot of money out of Bitcoin.  However, it is still a terrible investment — in fact, I don’t think we can even call it an investment — because it has no fundamental value and can crash to zero at any moment.  It will definitely do so; we just don’t know when.  So the problem is rather that people are using the Anecdotal Fallacy to assess the probability that Bitcoin will rise forever.  They do not consider the statistics on bubble which  have occurred widely throughout financial history.  Any “asset” which rises this quickly has been a bubble which has eventually crashed to zero value.  It will do so as quickly as it ascended.

So the statistics are diametrically opposed to our psychology here.  Stay away from Bitcoin at all costs.

*The reason I say “several decades” is because we have only been taking detailed measurements for about 150 years.  However, we have enough data from ice cores etc going back much, much further, just with bigger error bars.