Right now, you could be making several dangerous investing mistakes… and you likely don’t even realise it.
You see, stress causes our brains to react with powerful emotions. These unconscious, instinctive reactions can lead to big mistakes – even for the savviest of investors.
And investing in real estate is probably one of the most stressful, and emotional, transactions you’ll make in your life.
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What follows are three of the most dangerous real estate investment mistakes that can result in poor decisions… and how to be sure that you don’t make them.
1. The denomination effect
Have you ever had a large bank note, but didn’t want to use it to buy anything? Yet, you had no problem using a bunch of smaller notes to pay for something?
This is known as the denomination effect. Studies have shown that people hesitate to break a $50 note, but don’t mind spending three $10 notes and four $5 notes. When the value of a bank note is smaller, it makes us feel like we are spending less.
The denomination effect can also poison the brain of real estate investors.
For example, let’s imagine that a real estate investor, perhaps one who invests in rental properties, sees a home in an attractive neighbourhood that is priced well under the average price per square meter in that area.
He figures, sure, it’s probably cheap because it needs some work, but at this price it’s impossible to turn down.
The deal is done and suddenly our investor finds he has a money pit on his hands. By the time he’s finally made enough improvements to find a tenant, months have passed and he’s spent even more than he might have buying a more “expensive” property.
That is how the denomination effect works. Prices that are low can cause behaviour that results in spending as much – or even more – as would have been spent buying a property or stock with a higher price tag.
One way to deal with the denomination effect in real estate is to get a realistic valuation – and how much the required fixing up will cost. You also need to consider the time involved in making the property livable. These factors are relevant whether looking at the property as an investment or a home. Remember, what looks cheap at first sight may not turn out to be.
2. Loss aversion
Let’s say one month property values go up 5 percent. But the month after, they fall 5 percent. Of course, making money, even just paper gains, is better than losing money. But, is the joy of winning greater than the pain of losing?
Research has shown that for most people, it is not – losing feels worse and our minds experience actual pain when we lose money. The pain we feel from losing is greater than the pleasure we feel from winning an equal amount.
Hating losing more than loving winning causes investors to over-exaggerate risk and play it safe. So, even if the chances of making money are better than losing money, most investors will avoid the opportunity altogether.
Loss aversion can have a negative impact on real estate investors, particularly those who bought property at elevated prices during a bubble. Loss aversion often makes real estate investors reluctant to sell when prices fall, even when it’s unlikely that prices will bounce back anytime soon.
By hanging onto a property that has lost money, investors may miss out on the opportunity to invest that money in something more profitable.
So how can you overcome loss aversion?
The Overnight Test is a simple way to avoid making a bad decision because of loss aversion.
Say you invested in a property that declined in value and are now faced with the decision of whether to sell at a loss, or keep holding it. It’s painful admitting you were wrong, of course. But imagine you went to sleep and overnight the asset was replaced with cash. In the morning, would you now use that cash to buy the property at the current market price – or invest it somewhere else? If you wouldn’t buy the property even at this lower price, you should probably sell.
3. Status quo bias
Every investment, whether it’s stocks, bonds, real estate or commodities, fluctuates in value. Prices rise and they fall, and then they do it all again… and again.
Despite this predictability, most investors are caught off guard by these market cycles. Real estate price rise, oftentimes very quickly, and then the bubble bursts, leaving everyone surprised. It’s such a surprise because of status quo bias.
That means we tend to think things are likely to remain the same – because our most recent memory is of them being a certain way. Investors buy real estate in hot markets because they expect it to continue going up. Investors expect this because, well, the market has recently been rising. Status quo (Latin for “the state in which”) bias helps them forget about cycles.
Investors fall victim to status quo bias because they believe the four most dangerous words in investing: “This time it’s different.”
Of course, nothing is different. The cycle always prevails, the bubble bursts and prices fall.
Hong Kong’s supercharged real estate market offers one example. Between 2009 and September 2015, residential real estate prices more than doubled. But then in November 2015, sales and prices started tumbling. As of the end of February 2016, prices had fallen an average of 10 percent, and sales fell 70 percent compared to February 2015.
So this time was not different. Hong Kong’s currency is pegged to the dollar, and fears that the U.S. Fed would raise interest rates before the end of 2015 triggered fears that Hong Kong mortgage rates would also rise. The demand for housing fell and prices along with it – just like every other cycle that’s come before.
The best way to beat status quo bias is to procrastinate.
Behavioural economics studies have shown that if asked to make a particular decision about something by the end of the day, people are more likely to decide to leave things unchanged. Change is hard and the status quo is easy. And, when you don’t give yourself time to make a decision, it’s easier to keep things the same.
But, when people are asked to make a decision by the end of the week, they’re more likely to think carefully – and decide based on facts rather than the comfort of the status quo. That suggests change comes more easily if you have time to get used to it.
So the next time you think that this time is different, wait a bit. You may realise that, in fact, it isn’t different and almost never is. That can be difficult to accept when real estate markets are hot, but it’s a relief when the bubble bursts.
To sum up, we all have emotional responses we don’t full recognise when it comes to investing our money. Even the savviest investors sometimes give in to their emotions. So before you make another real estate investment, stop and make sure your emotions aren’t costing you money.