We like to think that we are perfectly rational—that every time we have to make an important decision, we do our research, carefully weigh the pros and cons, and then, like an impartial judge, decide on the right course of action.
We are also WRONG.
In fact, we all are subject to behavioral biases that impact every important decision we make. These biases act like psychological blind spots that our brains automatically fill in to give us the illusion of impartial rationality, when, in fact, the “dice” of our decisions are already loaded. Further, our brains are so good at the task of covering up these blind spots that everything happens in the background and we aren’t even aware of it.
The bad news is we all have these psychological blind spots because they came with our brain’s “operating system.” The good news is that once we know about them, we can make better decisions by being aware and taking precautions to offset their effects. In other words, the biases aren’t optional, but our subjection to them is.
Below, I will share three predominant behavioral blind spots that afflict real estate investors and some tactics you can use to mitigate their effects.
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Blind Spot #1: Self-Attribution Bias & Overconfidence
Essentially, when something good happens, investors attribute that outcome to actions they’ve taken, but when something bad happens, they attribute it to bad luck or external factors beyond their control. This bias is especially rampant at the extremities of the real estate cycle. For instance, when the market is on a positive run (think last few years) and values and rents are rising rapidly, a most confident real estate investor will give credit to their brilliant strategy or maverick moves. On the flip side, when the market is in a slump (think 2008-10) they ascribe the massive failure of their investments not to an overly aggressive and debt-fueled strategy, but to the overall market.
Furthermore, self-attribution bias causes the investor to discount the role that chance may have played in determining the outcome and to put too much emphasis on his actions as the cause. Inevitably, this line of thinking causes the investor to become overconfident and double down on actions that, barring the current favorable environment, would be disastrous.
So, what can you do to become aware of this behavioral blind spot and make better investment decisions? There’s a couple of helpful exercises you can do that will help you.
For the first one, you will need a partner: a spouse, a business partner, or a friend. Then, what you have to do is pitch and SELL the deal to them. Essentially, you have to explain to them why it is a good idea to make this real estate deal. Your partner either records your response or takes notes. After it’s done, review your recording or your notes. If, in your reasons for doing the deal, you sound overconfident or cite other deals you have done that were successful, you are exhibiting signs of this bias.
The second exercise that’s very useful is to perform a “what if” sensitivity analysis. In this exercise, you view your proposed investment through different lenses. What if rents dropped by 10%? What if interest rates rose by 1.5%? What if we couldn’t refinance? What if vacancy rates doubled? And so on.
By forcing yourself to evaluate the investment through these different scenarios, you make yourself be skeptical, which is the antidote for overconfidence.
Blind Spot #2: Loss Aversion
We tend to feel the pain of loss more intensely than the pleasure of gain. Therefore, most investors have the tendency to exhibit risk-averse behavior when facing gains and risk-seeking behavior when facing losses. For example, in a stock investing context, loss aversion can lead investors to hold a losing stock until it gets back to even—but to quickly sell a stock in positive territory because they’re “in the money.”
Another way to look at this bias is that it leads investors to work on their weaknesses instead of playing to their strengths.
A useful exercise that can help you combat the effects of this bias is to ask yourself: Would you buy it again at the price you could sell it for? Think about it—if you have the option to sell a property for a certain price and you don’t, you’re effectively “buying it” again at that price. So when you ask yourself that question and your honest answer is no, the only rational course of action is to sell it so you can focus on investing in winners. That’s how you beat back loss aversion.
Blind Spot #3: Belief Perseverance
Another lie we tell ourselves is that we’re open-minded to different alternatives, when, in reality, we seek information that confirms what we already believe. Or put a different way, we don’t want the truth; we simply want to be right.
Investors tend ignore information that conflicts with their existing beliefs. For instance, if they believe they’ve made a sound investment, they tend to discount any signs of trouble. Or if they believe that multifamily investments are better than single family investments, they look for information to prove that point and ignore any information that proves they could be wrong. They can even avoid gathering new information for fear it will contradict their initial opinion.
In order to avoid getting stuck in the quicksand of belief perseverance, it would help to discuss it with a partner who has your best interest in mind. This could be a spouse, an attorney, or an advisor. Present all information and data to them and ask them what they’d do and why. Sometimes, when you hear a perspective from a trustworthy source, it can be very persuasive. Most importantly, it could lead to a very different decision than the one you made by just consulting the “echo chamber” thoughts in your own head.
What strategies have you used to beat back self-attribution, loss aversion, and belief perseverance?
Leave your comments below!