How to Mitigate Your Risk by Playing Devil's Advocate

Optimism is an extremely important psychological trait. Indeed, optimists tend to be healthier and more productive, as well as just more pleasant to be around than pessimists. For an entrepreneur, there will always be struggles, and optimism is a critical coping mechanism in order to continue pushing ahead, even when the outlook is bleak.

But there is a downside.

Optimism can also cloud our thinking and tilt us toward too much risk. Or it can cloud our rational thinking with regard to an individual purchase because the human mind is biased towards emphasizing the upside of a possible deal and minimizing the downside.

Budget-Busting Optimism

I would wager you’ve heard the words “we went over budget” more often than “we came in under budget.” My favorite example of this is the Sydney Opera House, which was originally budgeted at $7 million and finally came in at over $100 million, a full 10 years behind schedule. Indeed, the list of such debacles is almost comical. For example:

The Scottish Parliament building was budgeted at 40 million euros and ended up costing 431 million.
A 2005 study of rail projects concluded that on average, planners overestimated the number of people who would use the new rail system by 106 percent and underestimated the cost to build by 45 percent.
A survey of American homeowners who had remodeled their kitchens found that the average person expected to pay just over $18,000 but ended up spending over $38,000. (Above examples from Thinking Fast and Slow, Pg. 250.)
In 1966, the House Ways and Means Committee made the “conservative” estimate that by 1990, Medicare would cost $12 billion a year (which included an allowance for inflation). Instead, it cost $107 billion in 1990.

What this all shows is that we almost always believe things will cost less than they will. When I first started budgeting rehabs, I came in woefully short. This was a big deal to us, as we get private loans to finance our projects and therefore if we underestimate our rehab expenses, we have to make up the shortfall out of our own cash reserves or ask for additional financing.

The first step to reign in this budgeting optimism is to realize that human beings are naturally hardwired to underestimate future costs. We may add up everything we see that needs to be fixed, but our minds trick us into believing the project will go smoothly and we won’t have any unexpected costs. We also often fail to spot the hidden costs (or downplay them), such as holding costs, financing costs and the like.

The best way to combat this is what has become known as “the outside view.” Namely, to take the past as an estimate for the future instead of going in cold. This is why it’s so critically important to review your results, even if you know they are bad and don’t want to have them rubbed in your face. The reason is because the next rehab project will, in all likelihood, look more like the previous one than the rosy optimism our minds will trick us into believing.

Using the data from previous projects (or from other people’s projects if you don’t have any under your belt yet) can help you figure out not only what things cost and how long they take, but what kind of contingency you should add for unexpected expenses. For example, I will usually add up the expected cost of everything I can find and put in my initial scope of work. Then I will add in holding and other extraneous costs, and finally I will put a 20 percent contingency on top of that. Using this approach, I have gotten pretty close with regard to budgeting. I will say that the experience of reviewing those budgets that were woefully off was not a pleasant one. But it was necessary.

Purchasing Optimism and the Devil’s Advocate

Nobel prize-winning psychologist Daniel Kahneman calls the optimistic bias most people have the “engine of capitalism” — in that it is one of the key sparks behind many an entrepreneur. And while that’s all well and good and has been paramount in creating prosperous societies and successful businesses, it is unfortunately often based on fallacious thinking. He gives one such example:

“Many years ago, my wife and I were on vacation on Vancouver Island, looking for a place to stay. We found an attractive but deserted motel on a little-traveled road in the middle of a forest. The owners were a charming young couple who needed little prompting to tell us their story. They had been schoolteachers in the province of Alberta; they had decided to change their life and used their life savings to buy this motel, which had been built a dozen years earlier. They told us without irony or self-consciousness that they had been able to buy it cheap, ‘because six or seven previous owners had failed to make a go of it.’ They also told us about plans to seek a loan to make the establishment more attractive by building a restaurant next to it. They felt no need to explain why they expected to succeed where six or seven others had failed.” (Thinking Fast and Slow, pg. 258-259)

There is a reason most new businesses fail. And one can surely infer that few people who’ve had a business fail thought it would fail in the first place.

I certainly don’t mean to dissuade you from entrepreneurship in general or real estate investment in particular. Both are great and can lead to financial freedom. However, understanding our inherent optimistic bias can help mitigate the risk of entrepreneurship and put you in the camp of successful entrepreneurs.

When we first came to Kansas City, we found an apartment complex that we thought was a no-lose purchase. (By the way, whenever you hear the words “no-lose,” you should become extremely skeptical.) The property was a 29-unit complex we were able to get under contract for only $450,000, or about $16,000/unit. We are from Eugene, OR, and a similar apartment would have cost well over $1 million anywhere in the city.

But we made a lot of assumptions and didn’t do enough due diligence. Optimism blinded us. Had we been more skeptical, we would have found that the current rents barely supported the building when it was full and that the per capita income in the building’s zip code was only $12,500. In other words, keeping the building full with paying tenants was by no means a given.

The building turned into a complete money pit that took three years to turn around. Finally, we have a performing asset, but it was in no way worth the cost. Indeed, it probably would have sunk us if it had been our first purchase.

But that being said, it was a valuable lesson in curbing our optimism with cold, hard reason.

When making such purchases, our natural optimistic bias gives way to a confirmation bias as we subconsciously look to find more reasons to support our initial decision (and our initial optimism). It is vital to learn to fight this natural instinct.

Today, for any large purchase, we first do our due diligence and simply try to gather as much information as possible instead of trying to craft a narrative. We then put that information together and redo our analyses. Finally, we schedule a meeting before our inspection period runs out. One of us is selected as the “Devil’s Advocate” and makes the case that we should not purchase this property. The person selected as the Devil’s Advocate is not to make a balanced case. They are making an all out case against the original decision, which we have to assume has been shrouded in an optimistic bias.

The others simply listen. Then we open it up for discussion and finally make a decision.

The key with regard to entrepreneurship is to use optimism to push you forward, but to be aware of its drawbacks and put in place procedures to curb its excesses. Optimism is good, but unbridled optimism is folly.

Have you ever been woefully off with your budget due to excess optimism?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.