“Everything popular is wrong.” — Oscar Wilde, Irish Playwright and Poet
“When you find yourself on the side of the majority, it’s time to pause and reflect.” — Mark Twain
Back when you were a young teenager, going against the popular trends was probably not fun. Instead, you tended to do what everyone else did because it protected your fragile self confidence from the ridicule of other kids.
But now we’re all adults. We need to hear the message from people like Warren Buffett and Oscar Wilde that says: Doing what is popular is dangerous.
Warren Buffett usually explains this principle by telling a story about lemmings.
A lemming is a small rodent that lives in the cold, far North tundras of places like Norway. These rodents normally live a relatively quiet, happy life, munching on grass and roots, but every 3-4 years, lemming populations explode and cause very strange behaviors.
Large masses of lemmings start migrating and following each other in erratic, bold, panicky patterns. They will start challenging larger, dangerous animals. They will climb over fences, rocks, and each other like their lives depend on it. In some cases they will just run off a cliff into the ocean and churn their little legs until they run out of energy and drown.
Very strange, I know.
Buffett says that large groups of humans also tend to act like lemmings. As a herd, we get very greedy or very afraid, and together we make irrational decisions that can only be justified because everyone else is doing it.
There is strong, psychological motivation behind group thinking. In the classic marketing and business book Influence: The Psychology of Persuasion, author Robert Cialdini spends an entire chapter on the concept of social proof, which basically shows that we humans decide what to do by looking around and observing what everyone else is doing. Popular decision-making is built into our brains.
Especially in social situations, this rule works well, but when popularity-thinking begins to dictate how you invest, how you will earn a living, or any other important life decision, it’s time to stop and think for yourself. The stakes are just too high.
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Invest Conservatively, Not Conventionally
“Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.” — Warren Buffett
Warren Buffett points out that even the highest paid money managers tend to make popular decisions in line with their peer group. Safety is usually equated with average or conventional. Intelligent but unconventional investments have a huge downside for money managers. Failure means they get fired. If they invest conventionally like everyone else, success or failure will at least keep them in good company.
After learning the true motivations, it should be no surprise that money managers rarely beat the overall stock market!
The real estate investment world is no different. Unless you want to fail in good company, you must guard yourself from conventional but irrational thinking. Your guard must especially be up with gurus on late-night infomercials, but you must even be careful with well-meaning advice at investment groups in your town or even on the Biggerpockets Forums.
How to Invest on Purpose, Not With the Herd
If not by popularity, then how then should we guide our investment and business strategy decisions?
Buffett recommends two main ways:
- By studying objective evidence
- By making rational and unemotional decisions
For Buffett, the objective evidence means closely studying the financial fundamentals of a company, just as a scientist would put an animal under a microscope. Buffett will examine the financial data on balance sheets, cash flow statements, sales data, operating reports and income statements. He will also put the management and the corporate culture under an equally intense microscope, looking for hidden strengths and weaknesses.
Related: Buffett and I
After finishing with the microscope, Buffett pulls out the telescope to see far over the horizon. Because his holding period is typically longterm, he likes to think about trends that affect a company over a 20 year period or longer. For example, in 2009 he bought BNSF, the nation’s largest railway company, in part because he foresaw rising longterm gas prices giving efficient rail lines an edge over gas-guzzling 18-wheeler trucks in the business of moving freight.
In real estate we can do the same thing by closely examining the market rents, the market resale prices, the true operating expenses and the many factors that make a location attractive or not. We must be patient and keep digging to ensure we get all of the relevant information needed to make a decision. If we are out of town, we must get “boots on the ground,” as fellow BP contributor Jeff Brown likes to say. If we can’t get good information, we must pass and move on to the next investment.
Like Buffett, we can also use a telescope to examine the big picture. Will your target market likely lose or gain people in the next 10-20 years? Will it attract jobs or lose them? Are there rare and attractive features of your location that make it a good place to live and work, like a beautiful lake, a university, a nature preserve, a solid infrastructure or an old town with character?
Finally, like Buffett, we must create our own set of objective criteria to guide our investment decisions and avoid the fevers of popular sentiments. If you didn’t get a chance to check it out, I summarized Buffett’s 3 business tenants in my previous article.
Three Objective, Anti-Lemming Real Estate Criteria
Here are my own current real estate investment tenets for buy-hold income properties. My attempt is to focus on conservative, rational criteria instead of the popular trends.
- Buy properties with attractive unleveraged yields from rental income. I usually measure this by a cap rate %, which varies depending upon how well it meets the second two tenets.
- Buy properties with potential to add value. This means I can do something to improve the income and the value of the property. This might be cosmetic improvements, better management, adding bedrooms, adding paid storage, lowering property taxes, etc.
- Buy properties with competitive advantages (castle moats) to protect future rents and values. In real estate this usually means a great location — both macro (within the county or the world) and micro (within a town). This competitive advantage makes it easier to raise rents, decrease vacancies and earn a lot more profits over the long run.
A well thought out investment process and a set of written criteria like this will give you something to hold onto when your lemming-nature and emotions of greed or fear drive you towards major or minor economic cliffs (and we are ALL susceptible).
If real estate does not meet your criteria, you should be very suspicious and price it conservatively.
What do you think? Do my recommendations and investing criteria make sense? Did I miss some? Do you have your own set of objective, anti-lemming investment criteria?
I’d love to hear from you in the comments below.