Understanding Cognition: Which Bias Is Affecting Your Crypto Trading? - The Curious Case Of Clustering Illusion

Have you ever wondered if your subconscious mind is conspiring against you; self-sabotaging your investment decisions? If not, and you take part in any sort of trading and investment, you probably should have by now.

Your brain is a remarkable thing, and so it should be. We are the end product of 4.5 billion years of evolution. Our brains allow us to manipulate and navigate a world dominated by the human race.

One of the amazing traits that has arisen in our brains that has allowed us to enjoy such dominance over the rest of the animal kingdom is, pattern recognition.

Law Of The Jungle

Being able to quickly define and spot patterns has an obvious evolutionary advantage. Back in the day before we sat atop of the food chain, having the ability to attribute certain patterns to wild animals would have been life saving.

Then later on as we began our agricultural journey, pattern recognition would have played a big part in raising animals and growing food.

Later still as our brains developed further, patterning helped us develop and discover art, mathematics, engineering, chemistry and physics.

On the whole, pattern recognition is good, we put it to good use practically everyday. However it is not always your friend. Sometimes it acts as a very sharp double edged sword.

Charting Clutter To Cluster

Inasmuch as pattern recognition is essential for efficient cognition. It is not a perfect process, and unfortunately it can often glitch out. Leading to what is known as the clustering illusion. This particular cognitive bias can have a serious effect on your investment decisions. Particularly if you are trading in cryptocurrencies.

Quite simply the clustering illusion is the tendency to see random streaks within a data set as having more significance than they actually do. This is because the human brain has a skewed view of randomness.

For instance I have just tossed a coin twenty times, and just made up a random sequence. The two results are below.

'H' stands for heads and 'T' for tails, can you tell which one is the true random set of results?

a) H H H T T T T T T H T H T T T H H T T T

b) H T H T H T T H T H T H H T H T T H T H

Which of the two is truly random?

Chart Statistics

If you trade cryptocurrencies, then there is a very real chance that you use charts to help you make your decisions.

This in itself is not a bad thing, the charts represent the entire market in an easily digestible format. Every single token that has been bought and sold in a particular market is tracked and documented.

By looking at the chart you are seeing a graphical representation of the history of moods and buying habits of the players involved in the market.

Charts are nothing new, they have been used in the stock market pretty much since the idea of stocks and shares blossomed within human thinking. However all charts can be viewed equally.

What's In A Chart?

We are of course talking about historical charts, and they ultimately represent a history of human behaviour within a given market. That fact does not change whether the chart is showing how many Christmas cards were bought last year. Or how many Z Classic tokens were traded last week. Both charts represent buying behaviour.

However the Christmas card chart is much more of a useful tool for predicting the future than the Z-Classic chart.

If you were an alien who had landed on earth looking at these two charts. If you went back far enough. You could reliably come to the conclusion that the best time to get into the Christmas card market, would be from late November to late December.

This is because the Christmas card chart not only reflects behaviour. It reflects a hidden reason behind the behaviour. In other words more Christmas cards are sold at the end of the year because it's about to be Christmas.

When it comes to stocks and shares, the reasons aren't always so obvious, however they do exist. One company's stock may go up because they hire a new CEO who is known for his brilliance. Another Company's might go down because of an expensive product recall.

There are some cryptocurrencies that are linked to real world events. For instance historical price rises in Steem prices have often come with an increase in the user base. Therefore more people are trading Steem.

However the price of most cryptocurrency is driven by speculation, which in itself is a completely random variable. This doesn't mean that there aren't reasons for an increase or decrease in speculation. It simply means that those reasons are due to many many random events.

Lumpy Randomness

So with all that being said, let's get back to why we're here. To explore why the clustering illusion has an effect on us when we're trading cryptocurrencies in particular.

It is because the clustering illusion is a glitch in thinking, that allows us to give undue importance to unremarkable, and completely expected patterns within a random data set.

Take the sequence I gave you at the top of the article. Which one looks more of a set of random coin tosses to you?

Be honest now, was it the second line? Which by the way has nine heads and eleven tails. Close to a fifty-fifty split, just as you'd expect in a coin toss.

Or was it the first line; with only five heads and fifteen tails; including a run of six tails? Not forgetting of course the perfectly A-symmetrical three heads at the beginning and three tails at the end.

The answer is of course the first, the fact is randomness, for want of a better word, is lumpy. It comes in clumps that are no more significant than the amount of raindrops that gather on a window ledge in a storm.

However we have been taught by our evolutionary past, that if we see any type of pattern where we expect randomness. Then that means it has some kind of significance to it. This is why random number generators that run internet gambling sites, are made less random, so that they seem more random to users.

This is where the clustering illusion can slip in and make you attribute significance to patterns that exist within random numbers. When in fact there is none. They are simply patterns you'd expect, which may or may not repeat themselves.

For The Buzz Of It

At the end of the day it is in our human nature to try and predict the randomness that surrounds us each and every day. We are creatures that wants to put an order to chaos. Indeed we strive to prove that there is no such thing as the word. It is merely an illusion, it is in fact order which we simply haven't learned the rules to yet.

Chaos however is real, and whilst one can argue that Bitcoin speculation is seasonal, and that the price of Bitcoin drives all the other alt coins.

You can easily counter with the fact that it can easily change at any moment, and it is far from an exact science.

A Chart Worth Watching

If you are going to use a chart that won't invoke the cluttering illusion in you. Use ones that are reflecting the current state of affairs. Like for instance the depth market which tells you how much money is sitting on the buy and sell side.

The depth market also gives you the spread, what people are willing to pay and what people want to sell for. Lastly it tells you what people are expecting to pay for in the near future, and what people want to sell for.

It is much better to make your purchasing decisions on real variables such as; how many people are in the market at any given moment, and what they are trying to buy and sell for. Than to make them on the basis of an illusory and insignificant pattern history.

Of course you can still be susceptible to other cognitive biases whatever charts you are looking at whilst trading.

That however, is for another article . . .

WHAT COGNITIVE BIASES DO YOU THINK YOU MAY SUFFER FROM WHEN TRADING? DO YOU BELIEVE YOU GENERALLY MAKE GOOD OR BAD DECISIONS?

AND WHAT RANDOM PATTERNS DID YOU SEE IN THE TITLE IMAGE, WHICH IS A MIXTURE OF MILK, WATER, PAINT AND OIL?

AS EVER, LET ME KNOW BELOW!

Further reading:

Cluttering Illusion - Wiki

[Introduction To Randomness And Random Numbers - Random.org(https://www.random.org/randomness/)

Title image: Joel Filipe on Unsplash

Cryptogee