We like to think we’re rational human beings.
However, last week I shared with you the concept that we are in fact prone to a group of cognitive biases that cause us to think and act irrationally, and this affects many of our investment decisions. Even thinking we’re rational despite evidence of irrationality in others is known as blind spot bias.
I shared with you the concept of Confirmation Bias, which is the natural human tendency to seek information that confirms our pre-conceived conclusions.
In my view confirmation bias is a major reason for investment mistakes, so I recommended you always attempt to challenge the status quo and seek information that causes you to question your investment strategies.
I also showed how the Bandwagon Effect describes gaining comfort in something because many other people do, or believe, the same.
This is also called “herd mentality”, but we know “the herd” is usually wrong – most property investors never build a substantial portfolio. So it pays to consider the concept of countercyclical investing.
I also discussed the concept of being biased towards overwhelming negativity or positivity – which often becomes apparent when couples are investing, and they realise they are in opposite camps.
Today in the second part of this two-part series, I’ll examine some further ways our brains sneakily convince us to make decisions that aren’t always in our best interests.
1. The Ostrich effect
When an ostrich is scared, the bird supposedly buries its head in the sand to stay ignorant of the approaching threat.
The (lack of) logic is presumably: “If I can’t see it, it doesn’t exist.”
Maybe it isn’t as ridiculous as it sounds, considering that humans do it, too. While we simply don’t have the neck length to literally stick our heads in the sand, people often deliberately look away from their money problems.
Some investors avoid unpleasant information such as reading negative financial news or checking on the performance of their properties, while many Australians bury their heads in the sand about their future financial security and put off investing all together.
On the other hand successful investors read as much as they can, talk to others who have a different perspective and surround themselves with positive supportive from people who help them form an objective view of what’s going on.
2. Choice-supportive bias
Here you prefer the things you own (even if they have flaws) over the things you don’t, because you made “rational” choices when you bought them.
For example, if a person buys a computer running Windows instead of one from Apple, he is likely to downplay the faults of Windows while amplifying those of Apple computers.
It’s just like when you’re convinced the investment you’ve just made is great because you spend so much time, research and emotion in selecting it. In fact, you rationalise your past choices to protect your sense of self.
Now you may not necessarily be wrong, but this is a bias you should be aware of in the future when reviewing the performance of your property portfolio.
3. Clustering illusion
This is the tendency to see patterns in random events. This is particularly true of gamblers who desperately try to ‘beat the system’ by seeing patterns of events in cards or the roulette wheel.
We are ‘pattern machines’ and recognise people and things from their overall pattern rather than full detail. While this is very useful, it does also mean we can see patterns where there are none. This selective thinking can lead to wrong conclusions when faced with the multitude of mixed messages we receive about the property market.
4. Curse of knowledge
You suffer from the curse of knowledge when you know things that other people don’t and you’ve forgotten what it’s like to not have this knowledge.
For instance, in the TV show The Big Bang Theory, it’s difficult for scientist Sheldon Cooper to understand his waitress neighbour Penny.
I see this in relation to property investment when I come across professionals who are successful in their own field and then believe they can translate that success into the arena of real estate.
Highly intelligent people often have difficulty asking for help or taking advice because they think they should be able to work things out for themselves. So they try to tweak, improve and fine-tune someone else’s property investment strategy interpreting it with their own biases, and then wonder why it doesn’t work so well for them.
On the other hand, I’ve found that many successful investors are “dumb” – they just find a strategy that has worked well for their mentors and follow it implicitly.
If you’re the smartest person on your team you’re in trouble.
This is the downfall of many investors.
In fact, one of the worst things that can happen to an investor is to get it right the first time they buy a property. This often happens when you invest during a property boom because you tend to think you’re smarter than you are.
This occurred recently when beginner investors bought in mining towns and property values initially rose significantly. Unfortunately, many are only now finding out that they weren’t as clever as they thought, as the value of their properties keep falling as the mining boom deflates and there are no investors to take these dud properties off their hands.
As you can see there are a number of personal preconceptions that can influence our success as an investor as they cause us to interpret information incorrectly and therefore make less informed investment decisions.
The best defence against this is to continue to ask questions and be sceptical of your preconceptions, so you can be in the best position to enjoy strong profits from property, both now and in the future.
This is deciding to act in favour of the present moment over investing in the future.
Of course we all procrastinate at times, but in the arena of property investment those who sat on the sidelines over the last few years waiting for the investment horizon to look clearer, have missed out on some fantastic opportunities.
7. Hyperbolic discounting
This is the tendency for people to prefer smaller payoffs now over larger payoffs later, leading one to largely disregard the future when it requires sacrifices in the present.
We all fall for this at times, you know… “Eat drink and be merry for tomorrow we may die.”
That’s because consequences that occur at a later time, good or bad, tend to have a lot less bearing on our choices today.
In fact, financial institutions such as banks and credit card companies build their businesses on hyperbolic discounting, because borrowing money and paying interest are actions that spend future resources for benefit in the present.
I guess that’s one of the reasons Warren Buffett said, “Wealth is the transfer of money from the impatient to the patient.”
8. Hindsight bias
This is the tendency for people to overestimate their ability to have predicted an outcome that could not possibly have been predicted.
The problem is that too often we actually didn’t “know it all along”, we only feel as though we did.
Ultimately, hindsight bias matters because it gets in the way of learning from our experiences because if you feel like you knew it all along, it means you won’t stop to examine why something really happened.
Hindsight bias can also make us overconfident in how certain we are about our own judgments.
It’s important to learn from our mistakes or missed opportunities so that you can become a better investor
9. Illusion of control
Illusion of control is the tendency for human beings to believe they can control or at least influence outcomes that they demonstrably have no influence over.
One simple form of this fallacy is found in casinos: when rolling dice in craps, it has been shown that people tend to throw harder for high numbers and softer for low numbers.
In property it’s the concept that you think you’ve got all your risks covered. In my mind risk is what is left after you’ve thought of all the things that can go wrong.
10. Information bias
This is the tendency to seek information when it does not affect action. More information is not always better. Indeed, with less information, people can often make more accurate assessments because too much can lead to analysis paralysis.
Successful investors take action knowing they don’t know everything yet, but they know enough to get started and are prepared to learn the rest along the way.
11. Post-purchase rationalisation
We all do some form of this at various points in our lives. We buy something. It’s not up to the standards we expected at all. Yet, we want to believe that we didn’t waste our resources, so we try to rationalise the purchase.
This happens much more often with impulse buys than with carefully planned investment decisions, yet many investors get carried away and buy one of the first properties they see, or get excited at a seminar and sign up for a property at the back of the room when they should have known better.
12. Skill bias
It is a scary place to be when the knowledge you accumulate outweighs your experience – and the worst part is, most people don’t even realise it when it happens!
There is so much information and education available to investors that many people feel they are qualified to make significant financial decisions, despite the fact that they have no experience to back them up.
Quite easily, novice property investors (and even those who have experienced moderate success) can begin to feel infallible and overconfident. This can lead to unfortunate shortsighted decisions, which can be very costly if the properties fail to perform as you’d planned.
13. Personal history bias
Depending on your experience in life, your viewpoint will likely influence your attitude towards investing.
Research shows that the way you feel about a topic is generally pervasive and was most likely shaped by events experienced in your youth.
Someone who grew up in the Great Depression, for instance, would have a much different attitude towards money and investing than someone who grew up in a family that experienced financial prosperity during the 80s.
These influences will show in the risks they are willing to take and the investments that appeal to them.
And now for a repeat of one of the biases I mentioned last week…
14. Bias bias
This is probably the most important bias of them all – the belief that you are less biased than you really are.
If you read these two blogs without realising I’m talking about you, you’re suffering from bias bias.
Michael Yardney is a director of Metropole Property Strategists who create wealth for their clients through independent, unbiased property advice and advocacy. He is best-selling author, one of Australia’s leading experts in wealth creation through property and writes the Property Update blog. Subscribe today and you’ll receive a free video training – The Golden Rules of Property Investment.