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.

It is not surprising that we are seeing larger audiences at real estate investing programs.  People are looking for ABS investments – Anything But Stocks – after watching their 401(k) plans drop 40% in value.  Housing prices have plummeted, and rates are historically low.  It’s a great time to invest in real estate.  But how does one get started?

The task can seem confusing.  There are so many variables, the decision process can be overwhelming.  First, there are several different ways to invest in real estate:  buying rental property, purchasing tax liens, options, and notes, even hard money lending and investing in REITs.  There are different types of real estate:  single family homes, condominiums, apartment complexes, commercial properties, and raw land. 

There is simply not enough room in this blog to do justice to the entire scope of information necessary to explain real estate investing, but a few key points are worth mentioning.  For more information, I strongly recommend that the new investor attend real estate investment seminars, talk to other investors, and yes, read the books and articles on real estate investing.  Most importantly, I urge the new investor to choose a small, low-risk investment and try it for a short duration. You will truly learn more “by doing” than what anyone else can ever hope to teach you!  You will also learn more about your tolerance for risk!

First Step:  Make a Plan.  The first and most important step is to consider both your personal and your financial objectives, and develop a plan based on these two factors.  You can do this while you are reading some books and attending seminars.  Just be sure to make a Plan before you write your first check!  For example, your personal goal may be to focus on raising your family, taking more vacation time, and getting more involved in community activities.  Your financial objective may be to earn enough through a combination of salary and investments to support your chosen lifestyle, and set aside enough for a retirement at a specified age.  Your financial objective should support your personal objective, not the other way around.

From this important step, you can start to determine how real estate investing can help you achieve your goals.  You need to consider how big (or small) a project you want to tackle, so that you can achieve your financial objectives without sacrificing your personal goals.  You also need to consider how involved in the process you intend to be – it’s the difference between “involved” and “committed.”  Think “Ham and Eggs.”  The chicken is “involved;” the pig is “committed.”  New investors who become Landlords quickly start to learn a lot more about plumbing, eviction procedures, and dumpsters than they ever thought they would.  One of reasons many people choose not to become Landlords is because they don’t want to be dealing with “toilets, tenants, and trash.”  It can be time-consuming, frustrating, and if you don’t manage it properly, the investment project can take over your life!   (Hint:  Hire a good Property Manager!)

There are basically three ways the investor makes money by investing in real estate.  The first – and some would argue the most important – is cash flow.  The formula is simple:  Income minus Expenses = Cash Flow.  Income from rents or leases need to be enough to cover your costs, which include your mortgage payments, taxes, insurance, maintenance and management fees.  The second way that the investor makes money investing in real estate is through appreciation – assuming that the property value increases over time.  An increase in value combined with the amount you are able to pay down the mortgage results in “equity,” which is simply a measure of the difference between the value of what the property is worth and what you owe on it.  The third way that an investor makes money investing in real estate is through depreciation – a pro-rated tax deduction that you use to offset a portion of the income over time.

Most real estate investors focus on the first two factors:  cash flow and appreciation.  As it turns out, you generally get one or the other – not both.  In areas where housing prices tend to climb steadily over time, purchasing at any price will result in a gain in value just by holding onto it for a long enough period, provided that the cash flow is not too negative.  It’s a relatively simple math problem, provided you factor in the tax considerations.  (Hint:  Learn to do some math and get a good tax advisor on your team!)  In some housing areas around the country, especially where there is good job growth, rents will be strong enough to generate positive cash flow.  Even if the value of the property does not increase all that rapidly, an investor can realize regular income from cash flow.  (Hint:  if the amount of rent is equal to or greater than one percent of the purchase price, it generally will have a positive cash flow.)

For a quick primer on some of the other factors you should consider before investing in real estate, I recommend that you read my article “The Five ‘P’s of Prudent Real Estate Investing.”  I also suggest that you find a real estate investment group or association in your area.  Many of these groups provide a wealth of information, advice and networking opportunities.  You will meet others like yourself, as well as experienced investors willing to share their knowledge and tips.  (Hint:  Be careful – everyone is different.  What works for one person may not work for another.  Listen and learn.)  Some investment groups provide bus tours of investment properties in your area, and teach you how to make simple investments.  Still others allow you to pool your money into investments, if that is what you would prefer to do.  Mostly, these groups give you the unique opportunity to meet and talk with experienced investors, learn about investment opportunities, and connect you with the key people who can help you:  lenders, brokers, financial planners, attorneys, tax specialists, and accountants.

Getting started in investing in real estate is really all about getting started.  Thinking about getting started won’t accomplish anything.  Take action.  Go to the library and check out two or three books on real estate investing.  (Hint:  Focus on learning the terminology; ignore the editorializing.  Many authors tend to promote the “one best way” to make money – there is no “one best way.”  And, Big Hint:  most of these books were written before the very recent housing crisis and market crash in 2008.)

One final piece of advice:  Invest, don’t spend, your money.  If your ultimate plan is to make money investing in real estate, invest in real estate.  There are several promoters who make a fortune selling seminars, software programs, CDs, books, and even cruises and board games about investing in real estate.  Some of these are excellent for learning about real estate investing, but choose wisely.  Some people spend all of their money into programs about real estate, rather than invest in real estate itself.  Ask yourself:  will the seminar, books, or materials teach me how to make more money than the cost of the program (including the cost of your time)?  Now, you’re starting to think like an investor!  Get started!

Starting on March 1, 2009, Fannie Mae will allow individual real estate investors once again to refinance up to ten (10) properties, relaxing the stranglehold limit of four that kicked in during the Summer of 2008.  According to the Announcement (09-02) issued February 6, 2009, the borrower will be subjected to some new requirements, including no history of bankruptcy or foreclosure within past seven years, no delinquencies on any mortgage loans in past 12 months; rental income must be fully documented; and borrowers must have six months reserves on the subject property and on each other financed second home or investment property.  In addition, the real estate investor or borrower must have a minimum credit score of 720, and the maximum LTV will be 70%.

Fannie Mae is expanding the definition of “reserves” to include all components of the monthly housing expense (PITIA), including principal and interest, insurance premiums, property taxes, special assessments, association dues, and any monthly cooperative corporate fee.

The Effective Date for multiple mortgages up to ten financed real estate properties will be March 1, 2009.  Fannie Mae has encouraged all lenders to implement the reserve requirements immediately and will apply them to all whole loans purchased by Fannie Mae on or after June 1, 2009.

It’s time to expand your portfolio!  For real estate investment opportunities in the best real estate market in the country — Houston, Texas — go to SpartanVentures.net.