We investigate the puzzle of widespread participation in cryptocurrency pump-and-dump manipulation schemes. Unlike stock market manipulators, cryptocurrency manipulators openly declare their intentions to pump specific coins, rather than trying to deceive investors. Puzzlingly, people join in despite negative expected returns. In a simple framework, we demonstrate how overconfidence and gambling preferences can explain participation in these schemes. Analyzing a sample of 355 cases in 6 months, we find strong empirical support for both mechanisms. Pumps generate extreme price distortions of 65% on average, abnormal trading volumes in the millions of dollars, and large wealth transfers between participants.

Applying a well-established neuroscience framework to the issue of investor perception of volatility, we propose that after prolonged exposure to high volatility, investors tend to underestimate volatility due to adaptation to the high volatility, and vice versa. Using a combination of field and laboratory tests, we find strong support for this hypothesis. The evidence suggests that this neurobiologically-grounded perceptual bias can cause distortions of asset prices in sophisticated and liquid financial markets.