Thursday, November 30, 2006
The Goal Of Successful Real Estate Investing
“Fortunately, we are not a bunch of computers walking around with limbs and big mouths. But if we were, we’d make far fewer investment mistakes” [Harry Max Markowitz, Nobel Prize 1990 in Economic Sciences and Professor Emeritus at City University of New York].
The human mind is very dangerous.
I am not talking about the capacity, unique to the descendants of the Homo lineage, to wage war, inflict destruction on to one another, ruin Nature and the environment, run other species to extinction, deplete natural resources, forge the powers of the atom for evil purposes, alter the genome and, in general lines, destroy anything and everything that Whoever is out there, by pure folly, one day decided to hand over to us. No, I am not talking about any of the above.
I am talking about the myriad different ways the brain can work against our own best interests in everyday aspects of life.
The very same capability for generating complex thoughts that allows mankind to be infinitely creative and which gives our lives richness and meaning, also contributes to less, far less desirable behaviours. Specifically as it relates to the investments landscape, it leads us to make inappropriate decisions the end result of which is a detraction from our investment returns. The good news, however, is that Behavioural Finance has made significant progress in uncovering some of the mysteries of investing psychology. Behavioural Finance is a particular specialty of the Science of Economics that applies scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources.
Behavioral Finance distinguishes among three general psychological traits common to investors that have a bearing on investment mistakes. They are:
This is probably the most inoffensive of the three psychological traits. It basically consists of two elements: lack of knowledge and innumeracy. The first is self-explanatory. As it applies to real estate investing, many investors generate sub-par returns because they either do not know or do not understand some of the investment basics. Or they simply have not been educated in the fundamentals of how real estate markets work and how to use markets characteristics to their own advantage. Lack of knowledge applies equally to general investors as well as to all those with specialized expertise, such as realtors and lawyers.
Innumeracy is a form of unawareness that is insidious, in that it is less obvious to most people. This is so, because it has to do with how most of us struggle with the Theory of Probability. Behavioural Finance asserts and recognizes that probability, specifically conditional probability, plays a much more significant role in investing than most of us realize. In very simple terms, conditional probability is the likelihood that event A will occur, given the known occurrence of event B. The reason why most investors get it wrong is because they underestimate probability. We all tend to think of unusual events as unlikely to occur, because our innumeracy inclines us to underestimate random patterns. When unusual events do occur, we label them as coincidences. But probability explains that there is a frequency of randomness between events, that can be expressed in Cartesian Algebraic form (this is, incidentally, the same frequency of randomness that Stephen Hawkings cites in his bestseller "A Brief History Of Time", which postulates The Theory Of Chaos as the basis for the formation and development of the universe).
In fact, the probability of some unusual event occurring at any given time is generally high. It is the probability of a particular unusual event occurring at a particular time that is low.
Real estate, we all know, is mainly a matter of emotion. Unfortunately emotion leads to distorted thinking, defined as the faculty of rendering superficial, quick judgements about reality. Have you ever been interrupted and cut short while you were trying to make an important point? It happens to me all the time in the course of my real estate practice. I used to think that ‘people don't listen'. Oh, they listen alright, but they jump to conclusions. It is an emotional form of irrationality that affects the human brain to varying degrees, and which is entirely counterproductive in the context of real estate investing.
Specifically, Behavioural Finance recognizes that heuristics (from the Greek ‘heurisko', i.e.:"I found it") are mental shortcuts that the brain develops in order to organize and synthesize information quickly. Unfortunately, data tends to become lost and, because of this, the representation of reality in the mind lacks focus. A common form of heuristics that relates to money is known as ‘gambler's fallacy'. The specific example is that of a gambler who, after tossing three heads in a row, is absolutely sure that the forth toss will be a tail. This thinking stems from our use of the law of large numbers to represent a smaller sample.
We all know that a good prediction of the ratio of heads to tails is 50-50, so we generalize that if we get 75 percent heads, at least 25 percent must be a tail. This is exactly what happens when you hear all those ‘bubbleologists' out there - that is all those intent at predicting real estate bubbles of all colors, shapes and forms - saying that real estate markets are bound to crash because we have had already a few ‘up years' in a row.
Now you not only know that the brains of all those ‘bubbleologists' are mush (as I have always stated) - you have scientific proof of it!
This is one of the most amusing examples of distorted thinking. Once in a while we all tend to reward ourselves with a nice night out, perhaps to a lavish restaurant - and an expensive one too. But on the way to the restaurant we circle around the block a few times in search of a free parking spot, so we do not have to tip the valet.
Mental accounting describes the irrational ways our brains use to put different expenses into different accounts in our heads. We do not mind debiting the ‘restaurant account' of a conspicuous sum, but we are much more stingy with the ‘parking account'. This demonstrates our ability to categorize money in many different ways, which is all and by itself a distortion of reality.
In light of the foregoing, one can appreciate how correct Professor Markowitz really is. Harry Max Markowitz is the Nobel Prize 1990 in Economic Sciences and Professor Emeritus at City University of New York. He declared "Fortunately, we are not a bunch of computers walking around with limbs and big mouths. But if we were, we'd make far fewer investment mistakes". We are disadvantaged vis-à-vis computers, in that we act illogically, irrationally and emotionally. None of us can be the Mr. Spock of Star Trek all the time. On top of that, we are largely oblivious to these weaknesses and this factor alone has the greatest impact on our investment returns.
Therefore, the goal of successful real estate investing is, first and foremost, to understand and master how our psychology affects investment decisions. Ignore emotion at your own peril. But understand how it works, and you will be better equipped to stay the course of profitability and above average returns.