How to Minimize Investment Blind Spots: Get Out of Your Comfort Zone — Part 2
As we discussed in the introduction to this series, heuristics are the mental shortcuts our brain creates to solve problems and make decisions as efficiently and as quickly as possible. These heuristics can be helpful in many situations because they reduce the time and energy needed to make decisions. However, heuristics can also lead to “blind spots” known as cognitive biases, which are the tendency to deviate from rational, logical-based thinking. To better understand how cognitive biases may occur in one’s thinking, a discussion of the various biases is warranted. Over the next two parts of this series, we will examine the many cognitive biases that investors should be aware of and tools for overcoming them.
This article will focus on the most common examples, which can be minimized by thinking outside the box, getting out of your comfort zone, and leveraging various sources of information.
Confirmation Bias
Confirmation bias is one of the most common, as it is simply the tendency to seek out or choose information that confirms one’s own set of beliefs. As it pertains to the world of investing, confirmation bias is like having tunnel vision, overlooking or disregarding any information that challenges one’s investment thesis. Confirmation bias can also result in overconfidence, as repeatedly obtaining the same types or sources of information can lead investors to become erroneously entrenched in their decisions. This bias can be mitigated by simply obtaining information from sources with different perspectives, sources that challenge an investor’s assumptions and investment thesis. The hard part of mitigating this bias is the acceptance of one’s analysis as incorrect.
Collaboration with others who have different perspectives and different mindsets is the key to beating confirmation bias.
These interactions will lead to exploring new insights and challenging one’s investment-related assumptions. Blind spots can be minimized with teammates who challenge one another, question the status quo, and ask “why are we doing it like this?” Investors should be open to receiving constructive criticism about their investment thesis and assumptions, as well as exposing their ideas to potentially unfavorable feedback. Investors should listen to opposing views and eliminate their confirmation biases when deemed necessary.
Information Bias
Information bias is the tendency to collect and analyze every piece of information, even when it is irrelevant to understanding or analyzing a potential investment. Investors need to be cognizant of what information is irrelevant and be able to make decisions without influence from said irrelevant information. We can see increasing potential for this bias to occur as digital interactions simultaneously increase. Investors continue to be bombarded with vast amounts of useless information and subjective opinions, plus mainstream media outlets that heavily taut traditional investments as part of the Wall Street Casino.
To overcome information bias, one must become a life-long learner, seeking out and fact-checking new (and perhaps contradictory) information sources before arriving at any decision.
The ability to minimize blind spots is also dependent on the amount of information an investor has. In addition to having in-depth knowledge of their market or asset, investors should also strive to understand the relationships with interrelated markets and assets for a big-picture view of that world. Perhaps the biggest driver of all investible markets is interest rates. Investors should understand trends around interest rates and the effect those changes have on their market(s) or asset(s). Every investor should make every attempt to stay ahead of the curve by seeking information from multiple sources and acquiring as much knowledge as they can. Knowledge is power, and it is the key to continually make better investment decisions.
Bandwagon Effect
The bandwagon effect is also known as groupthink or herd mentality. This bias comes from “jumping on the bandwagon” and investing in a market or asset class simply because most others are doing the same. From conforming to societal structures to adopting new trends, there is a human tendency to want to fit in. This phenomenon occurs in investing too. There is an undeniable comfort in doing or believing in the same things as other investors. This bias can be extremely dangerous, as speculative bubbles are usually the result of herd mentality. For example, an investor may ignore the merits of investing in commercial real estate (CRE) because most or all the people they know do not invest in CRE. Therefore, the investor chooses not to analyze and think independently of those in their inner circle. To be a successful investor, one must sometimes embrace taking the road less traveled.
We can also witness this bias on a narrower scale. The CRE investment space is overwhelmingly filled with sponsors and investors touting investments in multifamily. However, there are many other worthwhile CRE sectors, such as industrial real estate and senior housing, that have investment drivers just as good (if not better) than multifamily.
Two methods for overcoming the bandwagon effect are to (1) always consider alternative options and (2) spend more time with yourself. By consciously making these a priority, you can arrive at your own financial decisions with less influence from your peers or conventional information sources.
Familiarity Bias
Quite self-explanatory, the familiarity bias is the tendency to stay in a space that is known and thus, perceived as safe. This can be noted when investors tend to invest in only markets or assets that they are familiar with. Although staying in familiar territory has its benefits, like developing expertise in a market or having a preferred niche, this can make the investor susceptible to overcommitting their investments in a particular area. The familiarity bias can prevent the investor from moving out of their comfort zone and increasing their asset allocation (i.e., a mix of different asset classes) and diversification (i.e., a mix of investments in a specific asset class).
Casting a wider net and diversifying your investments can lessen the impact the familiarity bias has on your portfolio.
Anchoring Bias
Anchoring bias occurs when an investor heavily bases their investment thesis or investment decisions on an initial piece of information or past experience. This bias can cause an investor to latch onto some information or idea that objectively clouds their judgment. This can hinder an investor from actively researching and organizing the information necessary to make informed investment decisions. For example, a CRE investor may be focused solely on investing in multifamily because it was this sector’s investment thesis that they were initially introduced to. Perhaps they received above-average returns on their first several multifamily syndication deals, and have since made the conscious or subconscious decision that this sector provides the strongest ROI in the CRE space. However, they may remain unaware that they could have received the same or even better returns with less risk (i.e., more conservative investments) on syndication deals in others sectors of CRE, such as industrial and senior housing.
Anchoring bias is a powerful one, as that first piece of information gives context to any and all adjacent decisions. Investors must first simply strive to understand their anchors, and then rely on new evidence to adjust them accordingly.
Recency Bias
The recency bias occurs when too much value or emphasis is placed on recent information, and older or historical information is disregarded. Of course, certain events can change the price trajectory of markets and assets, but sometimes the recent information may or may not overcome or change the existing drivers or trends of a market or asset class.
Therefore, investors must analyze and weigh recent information with historical information.
For example, the COVID-19 pandemic has affected asset prices, but that does necessarily mean that investors should abandon certain investments? For example, the hospitality (hotels) sector of commercial real estate has been particularly hit hard by the pandemic, but does that mean that hotels will never be needed? No, it does not.
Do any of these cognitive biases resonate with you? If so, you are not alone. It is human nature to seek out information that is both familiar and confirms our predetermined beliefs, as well as behave in a way that “follows the crowd.” With some reflection and conscious effort, we can assess when and why these mental shortcuts work, as well as when they create roadblocks on our paths toward success.
Stay tuned for Part 3 of this series, where we will cover cognitive biases that led to impulsivity, pride, and oversimplification in investments.
For more information on passive investing in commercial real estate, please check out our free eBook — More Doors, More Profits — by clicking here.
Mo Bina
Managing Principal
High-Rise Capital
Website: https://www.high-risecapital.com/
LinkedIn: https://www.linkedin.com/in/mohrc/
