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!


Sand Castles vs T-Bills

Right now?

I’d rather own a sand castle than Treasuries.

Last week the 52 week T-Bill yield was .18%.  In other words…. lend the government $99,820 and they pay you back $100,000 in a year.

You lock in $180 profit on your investment.  For almost no risk.

Or… with that same $100k, you could buy a perfectly rehabbed rental house in a nice neighborhood.  At the end of the year, after taxes, insurance, maintenance and professional property management, you would passively pocket at least $6,000.

$6k in annual rental income… even if the house never went up in value.  With minimal risk.

$6,000 vs $180.

Oh… by the way… did we forget to account for inflation?

Even the most optimistic projections are betting inflation will exceed 2% for the next year.

So your T-bill is really going to lock in a loss of about -$1,820.

That’s right… it’s no risk… but you automatically lose money….

By contrast, your rental house will make you $4,000 AFTER inflation….and you will probably raise rents next year.

I guess it all depends how you define risk, right?

How do YOU define risk?  What returns are YOU looking for?  Please leave a Comment or share this post.


How To Sell a Flip on Your Own

So we bought a house, rehabbed it and are finally ready to flip it to a buyer.

Time for that important question… Sell it ourselves or with a Realtor?

We’ve previously discussed why to use a Realtor and how to pick a good one.

Now let’s look at selling the house WITHOUT a realtor.  If you are saving all that money on commissions, you better roll up your sleeves…. the real work is about to start.  While you can hire contractors to rehab, you are going to sell the house all on your own if you don’t have a real estate agent on your team.

Let everybody know you have a house to flip

Tell everybody.  Tell your friends, family, co-workers, people at church, folks you run into at the grocery store.  Other investors.  Realtors.  The tellers at your bank.  Tell everybody you have a great house at a great price.

You never know what connection might result in a sale. Use social media, email, phone calls.  Tell everybody.  When you are on your fifth house, you can slow down and quit bugging everyone.  Until then…. tell everybody.

Make a great flyer

Paper and ink are cheap.  Take the best photos you can, and design a full color single page flyer.  Give a complete description of the features of the house… but also give the benefits of the house- the emotional description, not just the facts.

“Large back yard” is a feature, while “huge backyard perfect for entertaining” is a benefit.  “New kitchen cabinets” is a feature….”brand new cook’s kitchen” is a benefit.  People buy based on emotion, not facts.  So appeal to your buyer with your wording.

Make sure your flyer uses words and phrases that sell.  Then give it to everybody.  Put a clear plastic box at the home. Mail them to friends and family.  Give them to everybody.

Online ads and Classified ads

Buy a cheap ad on Craig’s list.  See if your local paper offers online classifieds cheaper than the print version.  Check out your local “thrifty nickel” convenience store give-aways.  To really move a house, ask your local newspaper about a single color on neon paper flyer, stuck in the Sunday coupon section (sell the back side to a contractor).

Use words that sell

When talking about the house, creating the flyer, or drafting an ad, use the right words and phrases.  Beautiful, over-sized, impeccable, immaculate, mint, gorgeous, “walk in and fall in love”, “new landscaping”, “turn-key”, “move in”… etc.  These descriptions result in faster contracts at higher prices…. guaranteed.

What to avoid?  “Must sell” or “Motivated seller” are kiss-of-death phrases- they will slow you down and result in low ball offers.  Think about it… when you see these in an ad, don’t you expect a great deal?

Buy a big sign and/or banner

A standard yard sign is great, but why not spring for a 4’x4′ sign– it grabs a lot more attention, and you can put more information on the sign.

Also consider a 5’x3′ vinyl banner for a fence or the front of the house.  Especially in election season, when people start to tune out yard signs.

Price your house right

If your price is just 5% too high, you will get half as many calls.  Do your market research, and price the house right the first time.  It is tempting for new investors to initially price high so they “don’t leave money on the table”.

But time is money.  A fast nickel is better than a slow dime.  Repricing your house means new ads, new flyers, and new signs.  Get it right the first time.

Rehab your house right

If your house isn’t selling, and your price is right, then look at the quality of your rehab.  What isn’t done right?  What is scaring your potential buyers? Are they worried about the quality of that tile work… or do they think the house needs a new roof… or is the painting a little shoddy?

If your potential buyers aren’t offering, look to the quality of your work.  Only perfect houses get top dollar.

Ask for Feedback

Your best source of feedback is the people who see your house and don’t make an offer.  But you have to ask the right question.  Ask “what scared you”.  Then listen carefully.

They may hem and haw, but if you ask and then shut up, people will tell you exactly why they didn’t make an offer.  And if all it takes to get a contract is a new air handler or dishwasher… but your buyer is afraid of incurring that additional expense… seal the deal by agreeing to make that part of the contract.

ONLY work with Qualified Buyers

The single biggest mistake most new investors make is wasting time showing the house to a bunch of people who have no possible way of buying the home.

A Qualified Buyer is someone who has already sat down with a lender, given all the necessary documents (tax returns, pay stubs, etc) and had a credit report pulled.  If you are showing the home to someone who has not been through that process, you are simply wasting your time.

If you are showing the home yourself, you must screen buyers.  Ask if they are paying cash.  When they say no, ask which lender they are using.  If they can’t tell you, have them meet with YOUR loan officer or mortgage broker to get qualified…. BEFORE you agree to even show them the house.  Yes, you will piss people off.  You will hear “well I’m not even sure I want your house”.  You will have people tell you it’s none of your business.  But you will avoid wasting countless hours showing the house to people who can’t buy it.

What other tips do YOU have for people selling their own Flips?  Please leave a comment and share this post!