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: