Avoiding Bad Investment Decisions

As an attorney, I see the end result of bad investment decisions.  As an investor, I’ve made a few of my own.  Naturally, I wonder how these mistakes could have been avoided.  Would a better understanding of the psychology of investment decision-making  decision process help the investors avoid unnecessary losses?

Dr. Meir Statman, who holds the Glenn Klimek Chair as Professor of Finance at Santa Clara University Leavey School of Business, has written extensively on the topic of behavioral finance.  In a recent (Aug 23) article in the Wall St. Journal, “The Mistakes We Make - and Why We Make Them,” Professor Statman highlights the emotional impact of our tendency to avoid the “pain of regret.” Professor Statman theorizes that the tendency to hold onto a losing investment longer than necessary is caused by the need to avoid facing the reality that the investment has lost value.  As a result, the investor loses even more, even to the point of holding onto the investment until it has become worthless.  Professor Statman also notes the human tendency of investors to focus on realizing gain, which sometimes leads investors to sell a good investment prematurely.

In the WSJ article, Professor Statman provides eight “lessons” as a guide for investors to control these otherwise “normal” human tendencies that tend to adversely affect investment decisions.  He notes that “most investors are intelligent people, neither irrational nor insane.” But, the study of behavioral finance shows that we are subject to emotional influences that cause us to make decisions that are sometimes smart, and sometimes stupid.  “The trick, therefore, is to learn to increase our ratio of smart behavior to stupid.”

Most of Professor Statman’s examples focus on investments based on the stock market, which provides a convenient laboratory for studying reaction to changing conditions on a fairly rapid basis.   Would these rules apply in the world of real estate investments, where the valuation is based on different criteria, and the frequency of changes in value — at least in relative terms — is much much slower.  I would theorize, however, that the emotional factors are at least as strong as those associated with the buying and selling of stocks, in most cases.

Professor Statman’s lessons and his examples are worth reading.  Briefly summarized, he cautions against attempting to time the market; not to mistake hindsight with foresight; don’t let the fear of the pain of regret make you hang onto a losing investment too long; don’t just focus on success stories; avoid being driven by fear or exuberance; recognize happiness comes from gains in wealth, not levels of wealth; and to distinguish loss of wealth from loss of ego.  Professor Statman argues for diversifying your portfolio and using dollar-cost-averaging as a smart strategy to reduce regret and avoid losing your mind.

How could these lessons be applied to real estate investing?  The first lesson — avoid trying to time the market — is counterintuitive.  Aren’t you supposed to “buy low, sell high?”  In real estate, as in the stock market, there is a tendency to chase the market; to follow rumors and hype.  Following the herd is obviously a bad strategy for many reasons, but time and time again, you’ll hear someone say “So-and-so said on CNBC that Las Vegas/Miami/Phoenix was going to be the next hot market.”  Worst yet, people will claim to avoid chasing rumors, but pay thousands of dollars to so-called real estate “gurus” who will divulge a “secret” to the audience, and off they go.  Unless you are adding to an already diversified portfolio, chasing the “next best deal” is simply foolish.

Confusing hindsight with foresight is common, but could be disastrous.  Professor Statman states that “Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight.”  Yogi Berra put it bluntly:  “Making predictions is difficult, especially about the future.”  A forecast is just a prediction, and investment involves making an educated judgment about the future.  Just because a particular author or speaker claims to have made an accurate prediction does not guarantee that their next prediction will be any more successful.  Statistically, each new flip of the coin presents a 50% chance of heads or tails; success or failure.  The danger here is overconfidence.

Professor Statman, an expert in the field of behavioral finance, notes that ‘Emotions are useful, even when they sting.”  The tendency to avoid the pain of regret leads to hang onto a poorly performing investment with the false hope that it will recover, rather than face the actual loss that will result when the investment is sold or abandoned.  He urges investors to not “cry over spilled milk,” and start thinking about today and tomorrow; and not focus on regret.  Hanging on to a losing investment only postpones the inevitable and magnifies the pain.

Another lesson involves what Professor Statman refers to as “confirmation error,” whereby we focus only on successes, and look only at evidence that supports or confirms the favorable outcome.  By way of example, Professor Statman notes it is human nature to focus on the miniscule, statistical probability of winning the lottery, and ignore the fact that the vast majority of participants lose.  In any truly diversified real estate investment portfolio, there will be both winners and losers, and within the range of winners, there will be both big and small returns.  The question will be whether the winners, taken as a group, outweigh the total losses, for a net gain, but human nature is such that the focus will be only on the one, super-successful investment deal in the entire portfolio, and the tendency to mischaracterize the entire portfolio as performing at the level of the single biggest performer.

Professor Statman makes the seemingly obvious observation that one should not base their investment on either fear or exuberance.  Again, he cautions against trying to “time the market,” and resist the temptation to be motivated by either a fear of losing your shirt, or the exuberance of jumping on the bandwagon.  Similarly, he advises investors not to lose sight of your goal.  Professor Statman says a stock market crash is like an automobile crash.  The key is to focus on whether you can drive to the garage, or need a tow truck.  I would add whether you need an ambulance.  The point here is to recall what goal you were trying to reach, and evaluate what you need to do after the accident to get back on track.

Last, but not least, Professor Statman is a strong advocate of dollar cost averaging.  This strategy is well known as applied to the stock market, where the daily price fluctuations and unpredictable nature makes it almost impossible for the typical investor to outguess the market, so making regular and consistent purchases will balance out the “per share” cost over time, and hopefully reduce the regret factor.  Here, I will take a leap and suggest that Professor Statman’s “lesson,” applied to real estate investing, would argue for building a diversified portfolio of different types of real estate investments in different geographical markets, as a hedge against a total failure should any one type of real estate or any particular market suffer a significant decline in value.

The bottom line is we need to learn to increase the ratio of smart decisions to stupid ones, and recognize that the latter are often the result of emotional factors that we failed to recognize or control.  Doing one’s due diligence, fact-checking, and staying focused on your personal and financial goals, are all important considerations for the real estate investor.