March 12, 2025 | Read Online

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"It ain't about how hard you hit. It's about how hard you can get hit and keep moving forward."

— Rocky Balboa

The psychology of crypto investing

Every good market correction forces investors to stop thinking about price and start thinking about value.

What if, for example, the tech stocks I bought at 40x earnings are only "worth" 20x earnings — and what if the earnings number we're multiplying from isn't what we thought it would be?

Investing is an exercise in probabilities: We pay 40x for Nvidia because we think it'll keep selling GPUs faster than it can make them.

But when the shares fall 30 points for any reason, we start to wonder whether we should have been so sure about that — nothing has changed but our implied probabilities.

This is what makes stock market corrections first and foremost a test of behavioral finance.

Helpfully, a recent note from Morgan Stanley exploring the "psychology of expected value" enumerates the ways investors keep going wrong.

"Volatility drag and drawdowns," the co-authors write, makes it "psychologically difficult to deal with probabilistic systems."

If investors were robots, we'd arrive at a probabilistic estimate of expected value, place our bet, and simply wait and see how things turn out.

But we're not robots (yet), so much of our success as investors will be a function of how good we are at waiting it out.

Waiting is harder than it sounds.

"There are various challenges," the Morgan Stanley note explains, "including failing to accurately assess probabilities and payoffs, streaks of losses despite making positive expected value investments, and the practical and mental challenge of drawdowns."

Also, it never gets any easier.

"The psychology of surprise," the Morgan Stanley authors write, "is the study of how we react when outcomes differ meaningfully from expectations."

Or, as Rocky would put it, it's not about how hard you hit, it's about how hard you can get hit.

Crypto investors have been hit especially — and unexpectedly — hard recently.

We were promised a golden age of crypto trading, but got a murky age of trade wars instead.

How will we react to this surprise?

Badly, I'd guess — because all of the behavioral finance pitfalls of investing are amplified in crypto.

We overpay for lottery tickets.

"Research shows that investors commonly overprice stocks with lottery characteristics because they overweight the probability of a high payoff."

That seems even more true in crypto where every new L1 token is priced like it's the next Solana — they can't all be the next Solana!

We underprice extreme downside risks.

"Many outcomes investors call black swans are really…gray swans."

No one seems to think bitcoin could have another 70% drawdown, but why would that be so surprising? That's what it always does!

Extreme volatility undermines long-term returns.

"Volatility drag arises because of the compounding effect of gains and losses."

If a crypto token goes down 90%, as they so often do, it has to subsequently go up 900% just to get back to breakeven (which they don't often do).

We all think we're Babe Ruth.

"What is vital is how much money you make when you are right versus how much you lose when you are wrong."

We strike out a lot in crypto and that's fine — Ruth struck out a lot, too.

But we no longer hit as many home runs.

Against all recent evidence to the contrary, we keep expecting to make it all back on the next big swing.

We're risk-adverse after losses.

"In periods following large losses in the stock market, such as March 2009, the difficulty is not finding investment opportunities with attractive expected values but rather overcoming the aversion to losing more money."

In crypto, it feels like it's almost always March 2009, so we have a lot of loss aversion to overcome.

We do overcome it, every time — but not always in time to make any money.

We bet too big.

"Beyond a certain point bigger bets lead to less, not more, return."

I'd argue that crypto investors go beyond that "certain point" every time they buy a perpetual future.

There's too much leveraged trading in crypto, as evidenced by the constant losses that traders on the Hyperliquid perps exchange stubbornly endure:

We're too slow to update our beliefs.

"Probabilities and payoffs are dynamic. That means that new information will justify a revision of our prior probabilities."

Crypto investors are particularly terrible at this — we still seem to think that banks will use XRP tokens for cross-border payments, for example.

We're overconfident.

"A common mistake is 'overprecision' — being too confident in your views and failing to consider a wide enough range of alternatives."

I've never seen a more confidently held investing opinion than the year-ahead consensus that one bitcoin would be worth at least $200,000 by the end of 2025.

Bitcoin isn't definitely going to be the world's reserve currency.

Crypto is a "probabilistic system," just like the stock market.

We prefer stories over statistics.

"Experiments show that the impact on beliefs fades much slower for stories than it does for statistics."

ETH holders maintained their belief in the "ultra-sound money" story despite plentiful statistics suggesting that it wasn't very, well, sound.

They're certainly not the only ones — crypto investors have been hit hard lately.

But studying the psychology of expected value might help them keep moving forward.

— Byron Gilliam

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