Investing Psychology– Why You Do What You Do

Do you always think logically?  Always make rational decisions.

Probably not.  Even if you think you do.

“Prospect Theory” in economics says people make decisions based on the potential value of losses and gains, rather than the final outcome.

Under the Prospect Theory, investors make real world choices based on “Heuristics”… mental shortcuts… “rules of thumb”… that may or may not give us accurate results, but save us time in thinking up solutions.

Unfortunately, every rule of thumb that saves us time in making decisions has the potential to bias our decisions.

Let’s look at some of these cognitive biases…

1. Framing

We all have our personal information filters.  Our filters create a “frame” for the pictures we see.  The Frame then influences how we see the picture.  In short, the way we ask a question influences our answer to the question.  We draw different conclusions from the same information… depending on how that information is presented.

Our aversion to a particular risk depends on how a question is framed.  A question about how much profit you might make (positive frame) makes you more likely to pick secure options.  The same question framed in terms of how much you might lose (a negative frame) actually makes you more likely to gamble.

The positive nature of the first question influences your desire for security.  The negative frame of the second version makes you more likely to take risks.

So as an investor, do you focus on the profit potential of a deal… or the risk of loss.  Your focus actually subtly influences your risk tolerance… whether you know it or not.

2. Confirmation Bias

Confirmation bias is the tendency we have to favor information that confirms our beliefs.  We gather, interpret and remember information selectively.  And we interpret ambiguous evidence as supporting our existing preconceptions.

Have you ever bought a new car…. and then suddenly you see that new car EVERYWHERE?  You simply never noticed it before, because you weren’t looking for it.

When a real estate investor is pulling comparable sales for a neighborhood, we have a tendency to only notice the ones that support our existing idea of a fair price.  We overlook or explain away the sales that don’t conform to our notion of the right price.  When an appraiser finds different comps… ones that don’t support our preconceived notion… we are shocked and angry.

3.  Hindsight Bias

This is the “I knew it all along” effect.  We think things that have already happened are more predictable than they were before they took place.  Our brains lie to us to tell us we understood a situation better than we did.

When another investor buys a house and loses money, we tell ourselves that we were smarter than him, because we knew that house was a loser….  Even if we were bidding on that house and wanted it at the time.

4. Self-Serving Bias

The Self-Serving bias is when we take credit for our success… but blame our failures on outside factors.  The student credits her good grade on a test to her intelligence…. but a bad grade is the teacher’s fault for not teaching well.

As investors, we credit ourselves for recognizing the great deal that nobody else saw.  But if the deal goes bad… we can easily find someone or something else to blame.  We protect our self esteem by taking credit and assigning blame.

5.  Anchoring

Anchoring describes our tendency to rely on one piece of information when making a decision… even if that information is completely unrelated to the decision.

If I ask two investors to write down the last two digits of their social security number and then ask them to bid on something random (and they don’t know the inherent value), the person with the higher social security number will bid at least 60% higher than the one with the lower number.  The “anchor” adjusts our notion of value… even when it is obviously has nothing to do with the value of some unrelated item.

Anchoring is often seen when a potential buyer finds out what a flipper paid for the house at the auction.  They “anchor” to this price and adjust upward to pay what they think is a “fair profit.”  The price the seller paid is completely irrelevant… the only question that matters now is what the house is worth.  If the buyer wanted the best price… they should have gone to the auction and taken all that risk.  But buyers who anchor to that earlier purchase price can overlook the cheapest house in town because of their bias.

6.  Endowment Effect/ Loss Aversion

The Endowment Effect is when people demand more to give up an object than they would be willing to pay to acquire it.

If I give you tickets to the NCAA Final Four, your selling price once you are holding the tickets is going to be a multiple of what you would be willing to pay for those tickets.

Loss Aversion is related to the Endowment Effect.  It refers to our tendency to strongly prefer avoiding losses to acquiring gains.  Losses are twice as powerful psychologically as gains.

Would you rather get a $5 discount… or avoid a $5 late fee?  Most people pass on coupons all the time- but avoid a late fee like the plague. The exact same difference in price has a very significant effect on our behavior.

7. Sunk Cost Effect

Once you’ve made an investment, your cost has already been incurred and can’t be recovered. Your past expenses are irrelevant to future investing decisions.  The amount we paid for something should not affect a rational future decision… but it does for most of us.

Ever sit through a bad movie because you already paid for the ticket?  Rationally, you’ve already incurred that expense.  Now your choice is between suffering through a bad movie OR walking out to do something more enjoyable.  When did you last walk out of a bad movie?

Investors buy and rehab a house and then put it on the market with no response.  They know the price needs to be lowered…. but they also know what they have invested in the deal and want to recover those sunk costs.  Irrational.  But we do it all the time.

8. Irrational Escalation

Irrational Escalation describes people making irrational decisions to justify rational actions already taken.

Investors will increase their investment in a decision despite new evidence suggesting the decision was wrong.

Bidding wars are a great example of this.  Bidders who drop out at their predetermined maximum bid are being rational.  Bidders who end up paying a lot more than they wanted, to justify the time spent researching the auction and because they don’t want to get pushed around… not rational.

9.  Normalcy Bias

Normalcy Bias refers to people underestimating the possibility of a disaster.  People with a normalcy bias assume bad things won’t happen simply because they haven’t happened before.  We interpret warnings optimistically, using ambiguous information to infer a less serious situation.  In other words, we prefer the rosy status quo.

An investor who buys his first house with a sinkhole will be shocked…. all those other houses without a sinkhole conditioned him to believe such a disaster was impossible.

On a broader scale, the normalcy bias caused the current foreclosure wave.  Back when credit was plentiful, people with no income or assets could build spec houses… and nobody thought that was a problem.  The real estate market was booming, and nobody could see an end in sight…. because the status quo was a booming market.

Today REOs, foreclosures and short sales dominate the real estate market.  But soon that will all change, and an investor with a normalcy bias will miss the next boat.

So what “irrational” biases impact YOUR thought process?  Please comment below or share this post!


Home Rentals- the New American Dream?

USA TODAY is featuring a great article today entitled “Home Rentals — the New American Dream?

Here are some great snippets on the future of the rental market…

The foreclosure crisis will drive 3 million former homeowners to rent single-family homes between 2010 and 2015…

Single-family home rental was the fastest-growing part of the rental market, Fannie Mae says, citing U.S. Census data….

“In the next five to 10 years, you’ll see tens of billions, if not hundreds of billions, of dollars of private equity” pouring into the single-family rental business…

In the past six months, Colony Capital has bought more than 1,000 homes to turn into rentals. Most are in Arizona, California and Nevada, though Colony expects to expand into Texas, Georgia and Florida. In the next year, it will invest at least $1.5 billion in single-family rentals….

He says the growth of big-time investors in the single-family rental market is a “transitory thing” because it’s more expensive to manage them than multi-family housing. “The end game for investors is to sell these homes profitably in three to five years to owners….”

70 percent of those who lose homes to mortgage distress will own again. A recent Harris Interactive survey, commissioned by Coldwell Banker, found that 83 percent of renters want to own a home….

For Rent

What do YOU think about the upcoming rental boom?  Are you ready to capitalize on this trend?

Please leave a COMMENT or share this post!


Flip for income…Owner Finance for wealth

How long will this wave of foreclosures last?

And what’s next?

Our foreclosure market is WAY different than it was just a few years ago.  Back in 2009-2010, there were so many good deals, it wasn’t possible to buy them all.

The properties we did buy all had nice fat profit margins.  New houses, in good condition… easy to clean and flip.

We’ve definitely seen a shift since those “good ole’ days”.  The number of auctions has plummeted, while prices have shot up.  The banks have gotten better at calculating a realistic net price, there is more competition… in short we have much thinner deals.

So flipping foreclosures is tougher than it was.


Banks still like to get rid of crappy houses.  The older houses, in rough shape, in marginal neighborhoods, with huge repair bills…. the banks still don’t want those houses.  Especially the occupied ones. These are the steepest discounts at the foreclosure auction.

The problem is these older houses are a real bear to flip.  They sit on the market, competing with cheap newer houses, in nicer neighborhoods, at similar price ranges. And they sit… and sit…

So what can an investor do with these rougher houses?

Sell them with owner financing.  If the seller is willing to take a down payment and a note for the balance… even small, dumpy, older houses sell quickly… and for top dollar.

While there are a ton of available houses out there, how many work for someone with bad credit?  There are a lot of potential buyers who can afford a monthly payment but simply can’t qualify for a bank loan.

Sell to these buyers.

The good news is that flipping with seller-carry financing is quick and easy.  And (check with your accountant first), you can potentially save income taxes with an installment sale versus an outright sale.

The bad news is that it takes a lot of cash…. cash that might be better deployed buying flip houses.  Cash that will be tied up for years.  Cash you won’t see for a while.

But the long term return on owner financed houses can be a great wealth builder over time. It’s a solid source of passive income.  While the flipper has to keep buying and selling to make money, the owner finance seller collects a monthly check with no additional work.

Here are some tips on making owner finance work:

1.  Have cash

Owner finance is not a great “zero-down” investment strategy.  It works a lot better for the cash-heavy investor. If you have a mortgage on the property, you need to pay that off before you can convey title to your new buyer and take back seller financing.  If you have money partners for your flipping deals, you have a high chance of conflict when you suddenly switch to a plan that ties up their cash.

Selling with financing requires you to “take cash out of the game”… for years.  You are locking in a set return… but passing up on other potential deals.  There are much better opportunities out there for investors with a shaky war-chest.  Smaller investors will usually make a higher return focusing on straight flipping instead of owner financing.

Dollar Bill2.  Increase your Rehab Budget

While we are talking about cash…. plan on spending a LOT of it.  The houses that give the best owner finance return are not the big, new, clean houses that just need a little spit and polish– those are still your best flipping opportunities.

The best house for owner finance is the small, cheap, dumpy house that you pick up for a song.  They yield a much stronger ROI.  However, the reason they are so cheap at the foreclosure auction is the bank has determined they need too much work to bother with them.  So budget your rehab accordingly.

On average, we spend at least twice as much on owner finance houses as we do on flip houses.  The rehab has to be perfect… not just look perfect… because if a problem shows up a few years down the road, your owner finance buyer might walk from the mortgage payment.  And your owner finance buyer is putting most, if not all, of their savings into buying the home… leaving them no safety net to fix things that break when they move in.

3.  Organize your business

Collecting checks is passive, right?  Well…. not exactly.

  • You still have to hound late payers, just like a landlord.
  • You must check they are paying property taxes on time.
  • You must contact them if insurance is cancelled.
  • You will eventually have to foreclose on a deadbeat.

In addition, the IRS requires you to send Form 1098, showing the interest they have paid on the mortgage… which means you have to account for principal reduction and interest separately by using amortization schedules.  Owner financing is going to require more accounting and organization than flipping.

4.  Get Skin in the Game

The single biggest key to owner financing is to make sure the buyer has “skin in the game”.  The down payment needs to be enough to cause the buyer significant pain if they walk from the house.  You always want it to be less painful for them to pay you than for you to have to take the house back.

The more expensive the house, the smaller percentage you may accept as a down payment.  But generally, we like at least 10% down from an owner finance buyer.  More is better.

5. Higher Price, Lower Rate

Buyers of owner-financed houses usually just care about three things: the down-stroke, the monthly payment, and the rate.  Unlike other buyers, they are generally unconcerned with the sales price of the home.

While they make the purchase decision on what they can afford– not the interest rate– most buyers will take offense if your interest rate is more than they expect.  They have seen enough 3.79% rates advertised (for good credit), that they don’t want to pay too much more than that.

So if you offer a nice low interest rate (5-6%), you can sell the house for more… and still keep the monthly payment affordable.  You may say “but I can’t make 6%”!  Remember… your ROI is MUCH higher… because your Return on Investment is based on the cash you have in the deal, while the note is going to be for much more than that.

6.  What do Home Buyers want?

With most foreclosure flips, you need to make the house perfect.  The buyer is expecting to buy the nicest house in town at the cheapest possible price.

Owner finance buyers are a lot less picky.  They have a lot fewer opportunities to buy houses with owner financing than they would with cash or a bank loan.  They know that.  So the owner finance buyer is willing to overlook faults other buyers would not.

That said, the owner finance buyer wants all the major systems of the home to work.  They are usually giving you all they have as a down payment, and they can’t afford to replace a roof, AC, or wiring.  So include replacement or rehab of these items in your budget.  Even a marginal roof that might pass a home inspector’s report could derail your owner finance sale.

7. What do Note Buyers want?

Eventually you may want to cash out.  You may want to sell the income stream for a cash pay-off.  Note buyers love to buy seasoned, documented, discounted notes… as long as the terms of the note match what they are looking for.

Balloons, pre-payment penalties, terms…. these are all variables.  There are arguments for and against every variation.  You want to set up your notes to attract note buyers, even if you have no current intention of cashing out.  Just keeps more options available.

So find out who in your area buys notes.  Ask them what they are looking for in note terms.  Unless you have strong preferences, you may as well create a note that is easy to sell if you need to in the future.

There are plenty of people advertising to buy notes on a national basis.  But in my experience, you will get the best price from local buyers.  National buyers who are unfamiliar with your local market will insist on a much steeper discount to protect them from a lack of local knowledge.


Got any Owner Finance tips?  Please leave a COMMENT or share this post!