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I’ve been blessed to have met or listened in person to a few famous thinkers in economics and finance. One person, in particular, stands out, and that is Daniel Kahneman. Professor Kahneman is a psychologist and economist known for his work in behavioral economics, for which he won the 2002 Nobel Prize in Economics.
What this means is, he is an expert on the psychology of judgment and decision-making, in ALL manners of decision-making that involves money.
Buffett has said that temperament is more important than IQ when investing. For sure, one does not need to understand calculus or anything more advanced than arithmetic (in most situations) to analyze financials or companies. If you have a great temperament (read: understanding of psychology), that is alpha.
One of Kahneman’s books, Thinking Fast and Slow, focuses on the thesis that our thoughts are characterized by two modes:
"System 1" is fast, instinctive, and emotional. Example: going with feeling and gut instincts; “looks rare” and FOMO
"System 2" is slower, more deliberative, and more logical. Example: thinking in terms of probabilities; solving 12 x 13 (source)
System 1 is where many psychological errors happen, ones that are well known. And this System 1 is governed by our reptilian brains trained over millennia to act fast in situations where acting fact is lifesaving.
Decidedly, System 1 is not what we should be using when buying NFTs, and understanding some of the following psychological effects may help you. These effects can be described as either heuristics (shortcuts) or cognitive biases:
Heuristics: the process by which humans use mental shortcuts to arrive at decisions. Heuristics are simple strategies that humans, animals, organizations, and even machines use to quickly form judgments, make decisions, and find solutions to complex problems (source)
Cognitive bias: a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" from their perception. An individual's construction of reality, not the objective input, may dictate their behavior in the world (source)
So what are some common System 1 heuristics and cognitive biases when purchasing NFTs? Let me run through a few and some suggestions for dealing with them:
1. Anchoring
“What is the floor?”
“I paid X for it. What did you pay for X?”
“What was the mint price?”
These are examples of anchoring where we are sometimes influenced by irrelevant numbers, such as a recent mint price or an NFT we just sold. If you ask a group of people to guess a “random number” and flash a specific number, say 25, in the minutes leading up to the guess, it is very predictable many will guess 25 or something close to it.
Solution: Establish price ranges you are comfortable buying (or selling) beforehand and be mindful of how fast-moving Discord conversations or tweets may impact your own decisions of what to buy. If prices move out of bounds, don’t buy.
Writing down on a piece of paper or post-it “why am I buying this NFT and at what price?” will also help since you see it there physically.
2. Selective Memory and Overconfidence
You only remember the good experiences and heavily underweight the bad ones. Remember that 5x? Yep. Remember how much you lost minting crazy lizards? Nope.
Your confidence is substituted for actual knowledge. Therefore, you may start to think you’re infallible. As a result, you have a very distorted assessment of your ability. The fact that almost all (99.9%) of pfp projects will not hold value over the long run should factor into your calculations if you plan to be in NFTs in the long term.
Solution: Keep an open mind, maintain humbleness and realize what you buy could go to 0. Really digest that baseline failure rate. Doing this will push you into seeking more understanding and better crystallizing your thoughts. It will also, hopefully, help you size your purchases so as to not become overexposed.
Consider known unknowns and unknown unknowns: focus on what can go wrong.
3. Availability and Herding (aka FOMO)
The frequency at which things show up or how easily it comes to mind does not mean you should do it. In particular, if you see other people buying, creating massive whirlpools of attention in Discords or social media, remind yourself that you are a social animal, Twitter algorithms promote popular things in your feed that makes you want to click, and your logical brain that is really your alpha advantage cannot compete with any of it.
Our minds sometimes fail to grasp complexity, and our understanding of the world may come from a limited and necessarily unrepresentative set of observations.
Solution: Awareness of this psychological effect goes a long way. Slow down, take a few breaths, and speak OUT LOUD the next time you think you’re feeling FOMO “I am experiencing FOMO right now,” and see how that feels.
4. Loss Aversion
It’s well known that losing money hurts, but we experience losing money more sharply than if we had the equivalent in gains. Asymmetry.
What this means is, we don’t sell things when we should in the hope of it going back up again and not taking the L. But as we discussed above, most NFT projects won’t hold value, and even the most successful professional investors don’t bat over 50%/60%. So your NFT portfolio will most likely have a ton of NFTs that just won’t hold value. It’s normal.
Solution: Taking losses is acceptable. Having Ls in the portfolio is fine. Some top NFT collectors like Pranksy have THOUSANDS of NFTs in their wallets (that they bought), and they for sure are not batting anywhere near 90%. Taking Ls also allows you to have a little liquidity, focus on projects you love (focus/time is the scarcest commodity), and hey, if you’re doing it right, Ls will reduce your taxes end of the year.
Circle of Competence
Of course, not all psychological effects are bad. One important and very valuable heuristic is the concept of the circle of competence. A well-known example is from Ted Williams, one of the greatest hitters in baseball history and the last player to hit over .400 in a season (source).
Willams broke up the strike zone into 77 sections — 11 up and seven across. Each section has a three-digit number on it based on what Williams thought he would hit against that pitch:
There were fat areas (red/warmer colors) where Williams know he could bat 0.350-0.400. These were pitches that were helt-high and down the middle. Colder, gray areas on the periphery Williams estimated he would bat 0.230. Naturally, don’t swing if the pitch is in the lower percentage areas.
All of this emphasized Williams’s first rule of hitting: get a good ball to hit.
Unlike in baseball, in NFT buying you don’t get penalized for not swinging. There are no cold strikes and you can just wait for a nice fat pitch. Of course, you have to break up your own “strike zone” or “buy zone” into areas you believe you understand and can successfully swing for the fences on.
Don’t swing for Solana NFTs if you feel only comfortable with ETH ones. Don’t ape into things because others are. Prioritize System 2 thinking/understanding first and understand where your circle of competence is. Minting on-contract? Learn about it first, test it out, talk to people who understand first.
Fortunately, as humans, negative psychological effects can be minimized simply by just being made aware of them and the more awareness you have, the more control you have over your actions and how you swing your bat.
Thank you for reading and hope you enjoyed it!
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ETH: 0xbcbb9156f5fa29bf4bbf193f45ae8042c94e9008
Such good stuff.
A timely reminder for us all, Shorts. Did you happen to listen to him at Princeton? I very much enjoy reading your musings