You Are Prone to Errors—Avoid These 5 Scientifically Proven Mental Traps When Making Investment Decisions

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A standard economics textbook depicts humans as rational beings who always employ careful analysis to make the most advantageous decisions based on the costs and benefits of the available options. Since the 1960s, behavioral economists have questioned whether assumptions about human behavior in economic models are accurate, and research has shown that decision-making is often hindered by cognitive biases and heuristics inherent to how people think. 

Even humans who strive to be rational, such as real estate investors, are prone to errors in judgment. It’s not our fault—we’re human. 

Many shortcuts we use to make decisions in our daily lives are quite useful, but they can also backfire when we need to make a complex decision, such as whether to buy a rental property in a particular market. According to Fidelity, cognitive errors are particularly damaging in real estate markets. 

Behavioral economics is, therefore, a critical tool for investors because those who learn about their own cognitive processing can bypass their automatic decision-making system in favor of the evidence-based, rational decision-making required for a successful investment. 

When faced with a real estate investment decision, you’ll likely have a gut feeling about the best way to proceed. A good strategy is to immediately question your intuition and go through a mental checklist of barriers to rational decision-making, starting with these five cognitive traps that commonly ensnare real estate investors. 

The Anchoring Bias

The anchoring bias is a cognitive bias that causes real estate investors to incorporate a reference point into their investment decision—even if that reference point has no bearing on the potential value or outcome of an investment. Research suggests that anchoring effects are stronger when the decision-maker has less familiarity or personal involvement with the choice or when the choice is ambiguous. For example, novice long-distance investors or those acting in a volatile market may be more susceptible. 

A common example is price anchoring, a strategy retailers use to exploit consumers’ tendency to be swayed by reference points. For example, if a store keeps pricing on a television artificially high for a period of time before dropping it in a “limited-time sale,” consumers are more likely to think they’re getting a good deal, even if the final price is a high markup relative to the production cost. 

The anchoring bias is prevalent in many real estate investment decisions, and even seasoned investors can make errors due to the nature of cognitive processing. 

Examples of anchors include:

Asking price 

Researchers Northcraft and Neale found that the listing price for a property significantly impacts the perceived value of a home, even among an informed group of real estate agents. 

Two groups of agents were given two different asking prices for the same property, along with identical details about the property, and asked to determine an appropriate offer. Though agents were confident the asking price wouldn’t impact their appraisal—fewer than 20% acknowledged considering the reference point—the group given the higher asking price ascribed a much higher value to the home. 

The listing price is difficult to ignore, so Fidelity suggests that real estate investors focus on yield. Rather than determining a property’s value, assess its fair market rent and determine an appropriate offer price based on a return you’re comfortable with for that market. Though your offer may fall below the home’s value in the eyes of the seller, resist the urge to adjust your offer based on perceived value. 

Previous purchase price

A property’s previous purchase price also acts as an anchor for property owners, causing investors to be more likely to hold on to a property that has depreciated in value, even if this strategy is financially detrimental to the success of their overall portfolio. Loss aversion, which is the human tendency to weigh losses heavier than gains, plays a role in the phenomenon. If a property’s current value sits below the investor’s purchase price, they might keep the property, even if the money from its sale could be used to achieve greater gains elsewhere. 

Local market prices

If you’re a long-distance investor, you’ve overcome the home bias, which is a tendency to invest locally due to familiarity, even when equivalent information is available about an out-of-state opportunity. That’s an important achievement. Considering diversification across markets can lead to a more successful portfolio overall. But you may not be aware that prices in your local market act as an anchor when you’re investing out of town. 

The local market price anchor is especially harmful to investors who live in a high-priced market like Los Angeles and are investing in an affordable market like Detroit. For example, a study that analyzed transaction data in China found that nonlocal buyers tend to pay more for properties when they live in areas with high home values, indicating an anchoring effect. 

The Planning Fallacy

The planning fallacy is a cognitive error most people are familiar with—people underestimate how long a future task will take despite knowing that previous tasks took more time than they were originally allotted. This fallacy may have caused you to miss a flight or take on a project with an unrealistic deadline. It can also impact your investments if you’re not careful. 

People tend to underestimate the amount of time, money, effort, and level of risk required for an investment to be successful. This is especially applicable to the fix-and-flip investment. When relying on intuitive judgments, even experienced investors may predict a timeline that is shorter (and cheaper) than the statistical average for fix-and-flip projects. 

A prominent reason for this error is that people tend to focus on the factors they can control, forgetting about external risks. Issues such as permitting delays and contractor availability can impact any project, even if your remodeling skills or experience make you more efficient than the average investor. 

An obvious solution is to consult available data about fix-and-flip projects in your market. If statistics are available, resist the urge to adjust your timeline away from the mean due to optimism or confidence, but do incorporate measurable factors like contractor price quotes and real estate comparables in your range of estimates. Make sure your “worst-case scenario” budget and timeline estimate account for as many external factors as possible. 

The Framing Effect

The framing or context in which we make a choice drastically impacts our decisions. You might be more likely to choose an option that is framed positively, and you may take greater risks when an investment decision is framed in terms of losses.

Real estate fund managers may use framing to attract new investors. For example, they may downplay the risks while focusing on the relatively high return potential or frame their fees as a percentage of returns to make the cost seem low. Consider how you would feel about an opportunity if it were presented differently, and always do the math.  

Investors can also be victims of their own framing strategies. Fidelity argues that real estate investors tend to focus on the wrong frames, such as the average market return of an asset class, which is not an accurate predictor of the success of an individual property. Instead, investors should diversify their portfolios using lease structures, vacancy risks, and property-specific measures rather than only relying on industry frames like geographical location or real estate sector. 

Investing across markets and asset classes can be a great way to diversify, but investing in multiple locations doesn’t, on its own, make for a diversified strategy, especially if the markets are similar. Narrow framing can also cause investors to make mistakes, so it’s best to consider each decision in the broader context of your real estate portfolio. 

In addition, investors tend to make long-term property valuations based on existing market frames, though circumstances evolve, and to give too much weight to professional consensus about a market. Herding can also have a powerful framing effect, as we’ll discuss next. 

Herding

It’s reasonable to believe that a hot market is hot for a reason and act accordingly. A group of decision-makers may, in some cases, make better decisions than a single YouTube real estate guru—if you ask a large population to guess the number of marbles in a jar, for example, their mean guess will be close to accurate.

But because real estate investments often have a high degree of uncertainty, following the herd can backfire. If that same large population were asked to guess the number of marbles in a jar they’ve never seen, their mean guess would more likely miss the mark.

Uncertainty in investment decisions tends to lead to informational cascades, where investors rely on the ideas and actions of other investors who they perceive as having more complete information. But many members of the herd are followers, and even the leaders may not have access to more information than you do. Those leaders may be taking a risk that makes sense for their financial situation but not for yours. 

Herding, or following the crowd, also leads many investors to chase returns in hot markets, causing them to buy high and sell low. Because property prices increase when buyers flood a market, it’s often better to rely on data and independent critical thinking to determine which market will heat up next. Investors who followed the herd in Austin, Texas, in 2022 may now be kicking themselves. 

The bottom line: Do not sell because others are selling, or buy because others are buying. Instead, err on the side of going against the herd, and collect as much data as possible before making a decision. As investing icon Warren Buffett said: “Be fearful when others are greedy, and be greedy only when others are fearful.” Sellers can become emotional and sell at low prices due to herd behavior, giving savvy investors the opportunity to score a deal. 

Overconfidence and Confirmation Bias

People are naturally overconfident in their predictions, even when they have incomplete information or statistical information that doesn’t support the outcome they predict. In some cases, the effect can be worse for experienced investors if their reliance on their own knowledge and experience causes them to miss important steps in the due diligence process. 

People also tend to focus on information that confirms their current beliefs about whether an investment opportunity will be successful based on their experience, even though nothing in real estate is static. This is known as confirmation bias, and it may cause you to ignore or downplay useful data without realizing it. 

When you feel sure about an investment decision, consider why you might be wrong, not have enough information, or be accounting for unpredictable conditions. There is always a risk, and you should have a backup plan, regardless of whether you’ve been successful in the past. 

The Bottom Line

These are just a few of the ways human cognition can interfere with rational decision-making. If you’re interested in learning more, I recommend the book Thinking, Fast and Slow by the Nobel Prize-winning behavioral economist Daniel Kahneman. 

It’s important to recognize that intuitive judgments are sometimes wrong, that we tend to focus on the available information and ignore unseen factors, and that overconfidence (and the confidence of experts) can lead us astray. In short, there is no shortcut for independent critical analysis of a wide variety of data in predicting the possible outcomes of an investment decision, and you should prepare for unexpected external factors as much as possible. 

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.