Behavioural finance principles applied to

the financial bubbles: example of the 2017

cryptocurrency bubble

Adrien Bassani
BFA 3
Behavioural finance essay
Date of submission: 15/02/2019
Introduction

The formation of bubble on the price of an asset is maybe one of the most complicated themes

in economy. First of all, a bubble occurs when the price of an asset continues to increase while

it is already greater than its intrinsic value. Normally, the asset is tangible, it was the case with

the Tulip mania in the 17th century, and more recently with the real estate bubble in the 2000s.

On the contrary, numerous economists argue that cryptocurrencies, bitcoin in particular, are

intangible and their intrinsic value were equal zero.

Generally, the emergence of bubbles find just a few economic explanations, and often are at

odds with the classic theory. Even though, it has shown that some agents could be rational

during a bubble, a host of agents that participate to the bubble are not guided by the reason, but

more by euphoria and passions. Therefore, the main assumption, that is at the basis of numerous

financial theories, specifies that all the agents are rational seems to not be entirely true in such

a context.

The 2017 cryptocurrency bubble can be considered as one of the most fascinating bubbles of

the recent history. In January 2017, the price of a bitcoin was less than 1,000$, and it reached

almost 20,000$ in December 2017. Such an increase had provoked a huge enthusiasm and

interest from the non-financial press and the general public. As a consequence, the population

involved is really significant and diversified – not only made of finance professionals. From a

behavioural perspective, it is really interesting to study this bubble due to its extent and the

psychological biases observable.

In this essay, I will begin by pointing out the different behavioural principles and psychological

biases that can exist during the bubbles. Then, I will briefly show how the financial bubble

models have evolved since the introduction of the behavioural concepts. Finally, I will show

how the biases were observables during the bubble, and in particular during the 2017

cryptocurrency bubble.

Theoretical analysis and the example of the 2017 cryptocurrency bubble

I. Main psychological biases involved in a financial bubble

Since its development, the scholars in behavioural finance have pointed out numerous factors

that influence how an investor makes a decision. The aim of this essay is to show how these

factors are involved in the cycle of life of a bubble. These factors are known as behavioural

biases, which can be seen as a predisposed pattern of deviation from rational behaviour and

judgement. Hirshleifer classifies these biases in the four following categories: self-deception,

heuristic simplification, emotion or affect and social biases.

The overconfidence bias, which is included in the self-deception biases, is one of the most

influent biases during a bubble. It is notably the case when some agents underestimate the

probability of failure of their investments and have an excessive certainty in the accuracy of

their beliefs. Such overoptimistic behaviours have numerous implications on the financial

markets, and notably during a bubble. During a financial crash, it is the opposite effect, and the

agents tend to be over pessimistic. This bias can also be reinforced when the agents believe that

the success of their past investments is due to their own ability. Therefore, the positive

performance, that they had in the past, contributes to their decision making process and makes

them more reckless.

Another cognitive bias is the confirmation bias which also can encourage the overconfidence

of a trader. Indeed, an agent will tend to select the information that confirm his or her beliefs,

and reject (consciously or unconsciously) the ones which do not fall in lines with them.

In the heuristic simplification category, there is the representativeness bias which occurs when

an investor is too reliant on stereotypes and on generalities. Then, a major concept is the

anchoring bias, which emphasises the fact that an agent tends to be influenced by exogenous

data (the anchor) to assess the value of a good (a security for instance). The reference point (the

anchor) can be a random number or public information.

Included in the last category, the herd behaviour is maybe the most influential effects during

a bubble. It is when individual follows the decision of a larger group – which can be rational or

irrational.

Even though there are other biases that can be observable during a bubble, we will focus on

these ones, because they have the greatest impact on it. Moreover, they are strongly linked

between each other.

II. Evolution of the bubble models: from a rational approach to a behavioural approach

Before the introduction of the behavioural concepts in finance, most of the financial models

that explained bubbles had been based on the efficient market hypothesis. It led to assume that

asset prices always reflected the available information. Such hypothesis were based on the

rationality of the agents, and even if irrational investors could exist, their actions had minor

impacts. Nonetheless, the hypothesis of the rationality of the investor was rapidly questioned,

and notably in the case of bubbles. For instance, some scholars such as Fisher Black suggested

that investors trade on noise instead of on information. Then, Tversky and Kanheman pointed
out some behavioural biases, which conducted to a new approach in the model explaining

extreme financial events such as bubbles.

Consequently, different categories of models have pointed out the role of psychological biases

in a bubble, and how rational traders and non-rational traders can interact during such an event.

Another example of model is the one designed by De Grauwe and Grimaldi which introduces

the idea of the “boundedlly rational” agents –avoiding the distinction in two groups.

Besides, during the cryptocurrency bubble, and in particular for the bitcoin, it was possible to

consider distinct category of agents. Indeed, numerous groups were involved who arrived at

different moment of 2017 bubble. There were not only the bitcoin believers and founders, but

also financial institutions or professional traders. Clearly, each group did not have the same

behaviour, and some of them could be more or less rational.

It is important to note that most of the studies show that psychological biases can have an impact

on bubbles, but do not endorse the fact that they are the primary cause of their existence.

III. Effects of the psychological biases during a bubble

There are several impacts of overconfidence on the markets during a bubble. It can lead to an

increase of the trading volume and to excessive risk taking behaviours. For instance, investors

will take high leverages and will not be bothered by overpaying an asset. In so doing, they

largely contribute to the sharp increase of the asset price.

Moreover, Pr. Odean notes that overconfident traders tend to overreact to anecdotal and

irrelevant information. As a consequence, it can provoke extreme fluctuations on the asset price

during a bubble. It was the case during the cryptocurrency crisis, when the volatility reached

record, first when it comes to the increase, and then to the strong decrease.
Finally, when the bubble bursts, too overconfident traders tend to not believe that the decrease

will continue. As a result they will keep their position, and potentially loose a lot of money.

The anchoring bias will imply quite the same consequences when the bubble bursts. Indeed,

one of the most powerful anchors is the reference to a past trend or past periods. Anchoring

traders will continue to heavily invest in an asset, even if its price has decreased for two “short”

consecutive periods. Because, the reference point of the traders is the bull trend, and to them,

the recent decrease is an opportunity to have a kind of discount on the price of the asset.

Similarly, when the price of the asset crashes, such investors will encounter heavily losses.

In the aftermaths of the bitcoin bubble burst, numerous individuals lose a tremendous amount

of money because they were convinced that the prices will continue to grow. Some articles in

the media said that the bitcoin price could reach 50,000$, while it was about 20,000$. On the

other hand, they ignored numerous other information, including economist’s ones, that had

already said that bitcoin was a bubble.

Another explanation of such a bubble is the herd effect. It is more a social bias which refer to

mimic actions of a larger group. In the case of the bitcoin bubble, this bias was notably

observable, because it attracted numerous individuals who just followed the trend, and did not

have any knowledge about cryptocurrencies. We can also note that even professionals and

financial institutions decided to follow the trend, by trading cryptocurrencies. Their official

arguments were king of rational, because they said that the purpose was to have a market

position in this new field.

Conclusion

This study has pointed out that non-rational behaviours were clearly observable and linked to

the emergence of bubble. Psychological biases have a strong impact on the decision making

process of investors. Generally, there are other causes in the emergence of a bubble, but these

biases can amplify the bubble, in particular for bubbles such as the cryptocurrency one which

attracted a lot of people.

An issue and critic of the behavioural approach to explain a bubble is the difficulty to quantify

the effect of the biases. The behavioural models that try explain them tend to be very

complicated, even when it comes to showing the role of only one bias.

Finally, in the case of an euphory on the financial markets, it is really important to have in mind

these psychological biases, especially as future finance professionals.

Bibliography

De Grauwe Paul & Grimaldi Marianna (2004), Bubbles and Crashes in a Behavioural

Finance Model

Luuk van Gasteren (2016), The Effect of Overconfidence on Stock Market Bubbles, Velocity

and Volatility

Bertella, Pires, Rego, Silva, Vodenska & Stanley (2017), Confidence and self-attribution bias

in an artificial stock market

Keith Redhead (2008), A Behavioural Model of the dot.com bubble and crash

Dedu Vasile, Turcan Radu & Turcan Ciprian (2010), Behavioral biases in trading securities