What causes crypto market inefficiencies? What are the psychological biases in crypto investing?

By Gregory Mall, Head of Investment Solutions at AMINA Bank, CoinDesk; Translated by Deng Tong, Golden Finance

Despite the rapid development of the cryptocurrency market and the increasing attention from investors and regulators, its efficiency remains low. Although market efficiency has improved over time, research shows that even cryptocurrencies with large market capitalizations may not fully reflect existing information, resulting in serious inefficiencies.

Several factors contribute to the continued inefficiency of the cryptocurrency market:

• Low liquidity: Compared with traditional financial markets, cryptocurrency markets have lower liquidity and are therefore more susceptible to large price fluctuations and manipulation.

• Regulatory uncertainty: Inconsistent and changing regulations across jurisdictions create uncertainty, affecting investor behavior and market stability.

• Market Fragmentation:There are numerous exchanges with varying prices and volumes, leading to inefficient price discovery and arbitrage opportunities.

• Speculative Behavior:A large portion of cryptocurrency trading is driven by speculation rather than fundamental value, leading to volatility and inefficiencies.

Psychological Biases in Cryptocurrency Investing

Unlike stocks, which can be analyzed based on well-established valuation methods, cryptocurrencies tend to be less driven by fundamentals in the short to medium term.Since much of the value of cryptocurrencies is based on future assumptions, the asset class is susceptible to large swings based on market sentiment and liquidity. Empirical research shows that cryptocurrency investing is strongly associated with speculation and psychological biases. Here are some of the prominent biases in cryptocurrency investing:

• Overconfidence Bias:Investors often overestimate their knowledge and predictive abilities, leading to overtrading and risk taking.

• Herd Behavior:Investors’ tendency to follow the crowd can lead to buying cryptocurrencies when prices are rising and selling when prices are falling, which can cause market bubbles and crashes.

• Anchoring:Investors may focus on specific price points, such as all-time highs, and make decisions based on these anchors rather than considering broader market conditions.

• Loss Aversion:Fear of loss can lead investors to hold on to losing investments for too long or sell winning investments too soon.

Using Systematic Momentum Indexes to Exploit Inefficiencies

Technical analysis can come into play if an asset does not behave in a random walk. The Systematic Momentum Index can effectively exploit market inefficiencies while mitigating the psychological biases that plague individual investors. Here's how:

• Exploiting Market Inefficiencies: By systematically analyzing price trends and momentum, the index can identify and exploit inefficiencies in the market. This approach is based on the observation that assets that have performed strongly in the recent past tend to continue to perform well in the short term.

• Overcoming Psychological Barriers: A systematic approach helps avoid common biases such as chasing momentum and loss aversion. Instead of following the herd, the Momentum Index relies on objective data to make investment decisions. This reduces the emotional impact of market fluctuations on investment choices.

Added Value for Investors

For the average investor, a systematic momentum index offers several benefits

• Consistency:By following a rules-based approach, the index ensures consistent investment decisions, thereby reducing the impact of human error and emotional biases.

• Risk Management:The systematic nature of the index allows for better risk management through predefined entry and exit points, thereby increasing overall portfolio stability.

• Enhanced Returns:By exploiting market inefficiencies and avoiding common psychological traps, momentum indices have the potential to generate higher returns than purely passive investment strategies.

In summary, while the cryptocurrency market is inherently inefficient due to a variety of structural and behavioral factors, these inefficiencies present opportunities for systematic investment strategies. Momentum indices can not only exploit these opportunities, but also help investors overcome cognitive biases that often lead to suboptimal investment decisions. In doing so, it provides a valuable tool for navigating the volatile and rapidly evolving world of digital assets.