How to Minimize Your Investment Blind Spots: Impulsivity, Pride, and Oversimplification — Part 3

As we discussed in the previous article, it is human nature to seek out information that is both familiar and confirms our predetermined beliefs. It is also in our nature to jump on the bandwagon and follow the crowd. These are all examples of cognitive biases that can be minimized by thinking outside the box and getting out of our comfort zones. There are several more ways that investors can be hindered by their own mind, including impulsivity, pride, and oversimplification. In order to also overcome these cognitive biases, investors must first understand how they can show up in business dealings.

Restraint Bias

Restraint bias is a tendency to overestimate one’s inherent control over their impulses. For an investor, this can manifest as the notion that they will be able to have the restraint of objectively analyzing an investment and, if they decide to invest, they will not overspend. This is the belief that they cannot be mesmerized solely by the perception of an “amazing” investment opportunity. However, this is not always the case, and it can be fairly easy for investors to get caught up in the emotions of a highly touted investment.

To mitigate restraint bias, investors should have some rule-based process in place to control how much they will invest in any particular investment.

This process will also prevent subjection to concentration risk, which can occur when an investor has too many of their financial eggs in one basket (i.e., geographic market or asset type). By understanding how this bias shows up, an investor can proceed with a healthy level of restraint on any given deal — and take a beat if needed before moving full-steam ahead.

Incentive-caused Bias

Incentives are powerful motivation tools that offer a reward for a given behavior, but they also penalize for failing to behave in a certain way. The incentive-caused bias occurs when an investment does not have an incentives system or an alignment structure between management and investors. These mechanisms encourage management to make proper long-term decisions and exceed the stated performance, so it may seem logical to avoid deals that lack clear incentive.

Investors should evaluate a potential investment to determine if the alignment structure between management and investors is properly aligned and that investors are not taking on excessive risk.

In the case of stock market investing, management compensation based on excessive stock options can sometimes lead to the management’s decision to engage in stock buybacks, which increases a company’s share price and the value of stock options (rather than management making long-term decisions in the best interests of the company and its shareholders). In the case of syndicated real estate investments, the sponsor’s compensation should not be heavily dependent on charging fees. The sponsor’s overall compensation should be primarily based on delivering performance (i.e., making money for investors), and the use of return hurdles and a preferred return should help facilitate desirable incentive alignment between the sponsor and investors.

Loss-Aversion Bias

The loss-aversion bias is the tendency to not want to admit a poor decision was made. An expression of pride, this can mean an investor will unnecessarily hold onto a bad investment, refusing to sell at a loss and, therefore, hold onto the investment for the slim chance of recouping their costs. This bias can also be typical of stock, commodity, or foreign currency traders who hold onto losing trade positions in the hopes that prices will recover so that their trade positions can be closed at a breakeven price.

How can an investor overcome loss-aversion bias? They should invest in low-risk, high-reward deals and be able to admit when an investment does not pan out.

This bias is unlikely to occur in syndicated commercial real estate investments, as investment positions are illiquid and investments are held for multiple years. The illiquidity of the investment typically encourages investors to analyze the investment and its risks. Therefore, investors tend to make informed decisions.

Another effect of the loss-aversion bias is when an investor experiences a loss and then refrains from investing again as to not experience the potential negative emotions of losing. A more rational approach would be to analyze what went wrong and move forward.

Neglect of Probability Bias

There is a tendency to disregard or be unable to adequately characterize the probabilities for a potential range of outcomes. This can be considered a neglect of probability bias. The main outcome of an investment, from the perspective of many investors, is a singular event (i.e., the overall investment return). Investors tend to focus only on the outcome that they feel is the best or most probable. However, every investment begins with a range of potential outcomes.

A purely technical (and very challenging) analysis of an investment would involve the assignment of a numerical probability that each risk event may occur. The probabilities of these events can be plotted, and the resulting shape characterizes a distribution curve. The most well-known distribution curve is known as the normal distribution. In practical terms, almost all investors are unable to assign a numerical probability to the overall riskiness of an investment.

Investors should instead qualitatively determine if an investment aligns with their risk appetite and whether the investment meets their financial goals and needs.

By doing so, they can reduce this bias, and assume any incremental increase in risk should be commensurate with an increase in return.

Oversimplification Bias

In decision-making, certain concepts or issues cannot be easily explained or understood. There is a tendency to analyze only the simpler aspects of a decision and ignore what feels more complicated. This is called the oversimplification bias. Investors should strive to understand that certain investment decisions are inherently complicated or have elements of uncertainty and that these cannot be easily simplified. Investors should avoid oversimplifying the complicated concepts of an investment (or worse, ignore the investment entirely).

Investors should elect to understand the complicated concepts to the best of their ability before determining if the investment has merit.

This can mean asking for clarification, doing additional research, or consulting with a professional (e.g., legal counsel).

Stay tuned for Part 4 of this series, where we will circle back to cognitive overload and how its impact has grown in the Information Age, as well as why it is so important for an investor to understand the power (and shortcomings) of their mind.

For more information on 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/