How to explain to your brother-in-law at Christmas that Bitcoin is a bubble

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We all have one of “those” brothers-in-law. Some of them have knowledge about economic and financial matters Some may even have Bitcoins. But what is going to become a very difficult task this Christmas is convincing that brother-in-law that yes, the crypto-economy is the future and is here to stay, but that doesn’t mean that we aren’t in a bubble. In today’s analysis we give you reasonings, motives, and justifications with which you can try to make your brother-in-law see that there is a bubble in Bitcoin.

“Behavioral Finance,” is a term intimately related to behavioral economics and based on the same fundamentals. Behavioral finance is a hybrid branch between psychology, neuroscience, and economics, and applies to market behavior the latest scientific research in the fields of human cognitive and emotional trends, both individually and socially.

The applicability of behavioral finance to the economy and the markets is direct and very relevant, since you already know that from these lines we are always talking about the great importance in the markets of mass psychology and market psychology. It is a factor as relevant or more than published macroeconomic data, than the same regulations, or as business results, to name a few other factors. Indeed, the evolution of the markets is strongly marked by euphoria, ambition, fears, panics, impulsivity, passions, the contagion of ideas, etc. of the investors. After all, we are human, for everything: also to invest in markets. And that’s where our behavior as investors comes into play, and with it, by aggregation, the economy and behavioral finance.

One of the objects of study of this mixed discipline refers to the presence or absence of rationality in the decision-making of economic agents (investors mainly in this context). And in the heat of behavioral economics fashion, neuroscience has recently been added to the more classical psychology and economics  definition. Some have called this burgeoning field neuroeconomics, trying to explain certain behaviors of investors, and, above all, to predict them in the future.

In the current boom of the neoclassical economy of the last century, it sought to focus on the most natural part of the human being and investors, and even the concept of “Homo Economicus” emerged, which gave market decisions a rational sort of character. But the truth is that the psychological side never left economics, and even famous personalities and academics within neoclassical economics, such as Pareto or Keynes himself, made repeated reference to the more psychological side of investors.

But it was not until the end of the 1970s that the handbook of behavioral finance was published. The “The theory of foresight: Making Decisions under Risk” by Kahneman and Tversky had arrived, and analyzed precisely the anomalies detected in economic decisions that were not as rational as they should be. Now, with the latest advances in neuroscience and the ability to probe the brain and human behavior in new ways, economics and behavioral finance are more fashionable than ever.

Even today, there are supporters and detractors of behavioral finance. Mainly the resistance to include them in the equation of the formation of market prices comes from the hand of the followers of the efficiency of the markets. They argue that markets are self-regulating and efficient by themselves, and assume that behavioral finance is simply a series of anomalies that do not go beyond that. These anomalies occur both in the development of bullish and bearish markets.

And how does behavioral finance apply to the Bitcoin bubble?

There is a basic theory of demand in behavioral finance, which establishes several principles by which an investor and/or consumer is governed: they have their preferences for some assets/goods or others, they suffer from a limitation of economic resources, and due to the aforementioned, try to maximize their satisfaction or investment by choosing the most appropriate combination of assets.

In addition, and here comes the most interesting part, it is established that individuals adopt deviations from these fundamental premises, which leads to non-standard decision making. And who says standard means rational? Come on, the most irrational passions and panics that we sometimes see in the markets fall squarely in this category.

To explain it in simple words: we are talking about those sudden financial fashions that run like wildfire in the markets, which are transmitted by word of mouth (or by key to key), in which investors end up running behind the prices as if there were not a tomorrow, and in which one ends up investing with the incorrect approach that the asset in question will continue to rise to infinity and beyond (purely speculative approach). All these descriptive elements of a classic bubble under the behavioral approach are currently present in Bitcoin’s meteoric price formation.

After the excesses, then always follows a phase of reversion to the economic rationality of which the asset in question should never have been separated, and that ends up leaving multiple victims. It is again one of the scenarios par excellence of behavioral finance, and in which the market goes through the other side: panic, which ends up being as irrational as the preceding euphoria.

And now we have to explain all this to the brother-in-law…

The discussions with the most passionate Bitcoiners are endless. They get outraged at the mere possibility that there may ever be a bubble in Bitcoin.

The global character of Bitcoin makes it even more difficult to try to predict how far the explosive rise of this bubble will go, because the entire planet is entering at the same time into the same asset. But the bubble exists, do not doubt it, what happens is that those who have less experience in the markets believe that the bubble is only the descent, when the bubble is precisely a meteoric rise like the one we are seeing. The other side just being the single puncture of the bubble.

You’ll note that I never tried to predict how far the rise of the Bitcoin bubble will go. I am unable to do it (neither I nor anyone) with rigor given the current market conditions and the cryptocurrency. Some will say that then what good is it to alert them about the existence of a bubble, if you can become rich with prices that rise day after day.

The statistics behind these bubbling processes shows that the most prudent and smart thing is to refrain from participating in them, since in the long term they leave many more victims than newly rich.

First of all, I can make mistakes like everyone else, and when I am proven wrong, I will not hesitate to admit it to you and whoever it is: but when it is proven. But just let me explain how I personally deal with the dialogue and the debate with you, to which I dedicate so many nights in this medium.

One of the arguments that the bitcoin-unbridled wield when they already feel cornered, is that Bitcoin will never collapse because it is a scarce good by design, with a maximum number of Bitcoins of 21 million tokens. And that is true, but it is no less true that it is also true in most of the existing assets in the market, and all have suffered bubbles at some time.

In fact, economic science is usually said to be the science of scarcity, but what these bitcoin-outgrowths forget is that, apart from supply and its scarcity, the other indispensable variable in the price formation equation is the demand. And when the demand suffers, due to breach of trust or for whatever reason, the Bitcoin bubble will burst. This is where those behavioral finances that I mentioned before come into play again, a market discipline that only the most experienced analysts and investors take into account, before being dazzled by new assets “that are different in time.” And I can even admit that they are, but what I tell you is that what does not change is human nature.

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