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!


Foreclosure Hazard Stories… #46 and #47

It doesn’t seem to matter how long you do something… there is always something new to learn.

In the past week we’ve had two “learning experiences” I’d prefer to have skipped.

1. You Need Accurate Info at the Foreclosure Auction

Accurate information is a must.  Everybody knows that.  But we learned today  information can be “accurate” and “misleading” at the same time.

We have a spreadsheet listing every property for each day’s foreclosure auction.  Our list has all the information we think we need to make intelligent decisions… case number, names, address, size, year, type of construction, etc.  This way if the bank offers a deep discount on something we didn’t see, at least we have a fighting chance of deciding whether to bid.

Well, there wasn’t much of interest at this particular sale.  But there was one property where the bank’s maximum bid seemed really cheap.  We were generally familiar with the area, even though we had not seen the particular house.  It was a new house, on a little bit of land, in an area of farms. And it sounded like a great deal.

So we bid on it, won and paid the deposit.  $3k in cash.

Then we drove out to see our new house.  And then we realized our mistake.

Well… the mistake of the person who prepared our spreadsheet.

See, our list said this was a “2034SF/08” house.  That means it is just over two-thousand square feet of living space, built in 2008.  Or, at least, that’s what it is SUPPOSED to mean.

Turns out… this is a 1908 house.  Not a 2008 house.  Hundred years off.  Our spreadsheet was accurate… it was in fact an “08” house… just not “2008”.  That’s extremely accurate and incredibly misleading at the same time.

A 2008 house would have been a no-brainer… easy rehab and flip for top dollar. 

A 1908 was also a no-brainer…. forfeit the deposit.

Any way… lesson learned, right?

2. You Just Can’t Avoid Crazy People.

We bought a great house about a month ago.  The owners had done everything they could to keep the house… filing answers, counterclaims, motions and appeals.  They had even filed a separate federal lawsuit, alleging the foreclosing bank committed fraud.  ALL of this crap had been summarily dismissed.

We had to evict the owners, who still thought the federal lawsuit protected them (even though it was dismissed months earlier).  They were a little nasty about it… telling our agent that he needed to find a better job, wasn’t getting paid enough, and didn’t know what he was talking about.  However, once the Sheriff posted the writ, they moved all their things.  Surprisingly, they even left the house relatively clean.

So we rehabbed (tile, carpet, counters, paint, pool screen, etc) and put the house on the market.  Got a contract right away at our asking price.

Great.  Just the way it is supposed to work.  Everything is perfect.

Then right before closing, the old owners filed a “lis pendens” in the public records.


Now, all a lis pendens does is warn people a property is involved in litigation.  This particular lis pendens is complete bullshit… it references the state foreclosure case and the federal case they filed… both of which have been dismissed and appeal times have run.  So the “pending” action it supposedly warns of is non-existent.  And it doesn’t even give the property address, so it doesn’t meet the definition of a lis pendens either.

There is absolutely no merit to their claim, and we will have it resolved within a week.  Luckily, we know exactly what to do, and can handle this inexpensively and quickly, since we don’t have to hire outside legal counsel.  More importantly, these owners filed their bullshit paperwork with enough lead time that it won’t screw up our closing.

But you can’t predict Crazy. 

And if this had happened to another investor… or happened a little closer to the closing… it could cost a LOT of money.  And it could cost the deal.  Obviously Crazy Owner has no money… so even if the court sanctions them for wasting everybody’s time, good luck collecting.

Just another risk of buying foreclosures at the auction.  Luckily this one wasn’t our fault and could never have been predicted….

What other risks have you seen at foreclosure sales?  What have Crazy People done to mess up your investments?

Please COMMENT below– Thanks!


How to pick the perfect foreclosure flip house

What kind of property should you focus on buying?

If you are flipping, it’s simple– buy whatever you can sell quickly and profitably.

But first, you first need to know:

  • Who is my ideal buyer?
  • Where does my buyer want to live?
  • What is my buyer looking for?

In our market, these are very simple answers.

We know our buyers are looking for entry-level homes (most are first time buyers).  There are also a large number of “consolidated families”, so they need a fair amount of room.  Our buyers are very cost conscious and are looking for a great deal.  They want an affordable mortgage, and they want the most bang for their buck.

We’ve developed the following standards for evaluating homes and neighborhoods.  90% of the homes we buy fall under these guidelines.

Avoid Small Houses and Two Bedrooms

Anything under 1,200 square feet of living space (air-conditioned area of the home) is difficult to sell.   A house that small is usually a two bedroom, and only about 15% of buyers are interested in these smaller homes. So if you want the broadest appeal, make sure you stay away from the small houses.  Our exception to this rule is in one of several large retirement communities, where a 2 bedroom is common and desirable.

NOTE: I love the “tiny house” movement– people turning sheds, trailers and other tiny structures into actual living space… but good luck flipping those!

Avoid huge houses

The sweet spot in our market is 1,600-2,000 square feet of living space.  That’s generally a 3 or 4 bedroom house (sometimes with a bonus room).  That’s big enough for families (even with an unexpected long-term guest or two), but still very affordable.  Anything bigger than that, and the price is usually too high to attract a large number of interested buyers.

Stay under $150k… or even $100k

Our market data shows 87% of all single family homes sold in the past year were under $150,000, while 65% were sold for less than $100,000.  That doesn’t mean you can’t make money on more expensive homes, but be aware of just how many buyers you are excluding when you get to those higher price points.  If you want multiple offers on a house within a week of listing it…. stay under $75k.

Look for Nice Neighborhoods

This is all relative.  We sell plenty of houses in neighborhoods I wouldn’t want to live in personally.  But everybody wants a quiet street.  Nobody wants to live in a war zone.  Everybody wants nice neighbors who take pride in their home’s appearance.  So don’t buy houses on busy streets or in unsafe neighborhoods or in ugly neighborhoods.

Look for a Garage or Carport with Storage

Most of our buyers are younger couples with children.  They have cars, toys, mowers, hobbies, and lots of stuff.  They need a place to store all this stuff.  As a result, a house without a garage takes considerably longer to sell, especially if it is in a neighborhood where the other homes have a garage.

Buy the Ugliest House on the Block

With a house, you can always fix ugly.  Pressure washing, mowing the yard, hauling off trash, a fresh coat of paint, newly planted flowers, a new roof…. knocks the ugly off pretty quick.  But make sure your pretty new house is just a little nicer than all the other houses.  If it is obviously that much better than its neighbors once you are done, you’ve “outbuilt” the area and won’t get the best return on your investment.

Buy Newer Houses

We had a building boom from 2004 to 2007, right before the crash.  A lot of these were “spec houses” that were never occupied by the original owner, and they still make up most of our foreclosure market.  With all these “new” homes (less than 10 years old) flooding the market at very competitive prices, it is much more difficult to flip an older home.  The older homes, in well established neighborhoods, make fantastic rentals or owner-finance properties, but are very hard to flip to people who have seen all the “new” homes out there.