This article was generously contributed to our blog by Amber Jane.
Any form of investment costs not just money, but also time. There’s also the need to consider all the risks involved in pursuing greater financial aspirations. All of this makes investing a potentially complex and emotional endeavor, especially in real estate investing.
As much as investors want to view their investment behavior as objective and evidence based, people’s decision-making processes are heavily influenced by emotions and are vulnerable to cognitive biases. Behavioral finance, while relatively new, is an emerging field of psychological study that aims to uncover these psychological traps and develop new investment strategies.
Analysts in the private sector are increasingly looking to psychology to help them understand how to integrate its principles into the corporate world. Maryville University's academic guide for psychology graduates notes how the corporate world is employing more psychologists to help with decision making processes. This is because smart investors understand how cognitive biases affect their decision-making faculties. They are then able to use the expertise provided by business psychologists to avoid psychological traps when investing.
Below are 5 such traps:
The “First Impressions” Trap
Also known as the anchoring bias, this cognitive trap makes someone pass judgment on an investment based on their first thoughts. This can sometimes be seen when investors let the initial offer color their judgment and decision making process.
People with this bias cannot see the other variables after forming an early opinion of the deal. Taking a step back and assessing the whole picture before making a decision is a fundamental skill in property investment. Never solely base decisions on the listing or appraisal photos. Instead, look at the property’s history, how the market has received it so far, and the reports or analyses of experienced professionals.
Everyday investors, however, often lack the ability to gather and review all the relevant information themselves to analyze a given project’s investment potential. GROUNDFLOOR provides an easy way for investors to evaluate investment opportunities at a glance with loan letter grades, which are assigned based on a proprietary, SEC-qualified grading algorithm that takes important factors such as appraisal values, developer experience, scope of work, and “skin-in-the-game” into consideration. Loans are graded from A to G, corresponding to the relative level of risk the project has, so investors can make investment decisions that align with their unique risk tolerance.
The “My Instincts” Trap
People have biases they sometimes call “instincts” which can often get in the way of decision making. In this cognitive trap, you tend to see only the data you want to believe in, and thus overestimate non-representative data. How something is presented can change how investors view a specific real estate investment. Always do extensive market research before deciding on a deal rather than going with your gut.
The reverse is also true. For example, the ubiquity of unscrupulous hard money lending during the 2008 financial crisis has smeared the real estate investing space so badly that many are still wary of participating — despite it being a legitimate (and lucrative) alternative asset class. GROUNDFLOOR’s commitment to protecting customers’ interests through rigorous underwriting and asset management standards allows investors to rest assured that projects on the platform are being carefully screened and monitored to ensure that they will be successfully completed.
Additionally, the company regularly releases analyses on historical and current loan performance, as well as the average returns of portfolios on the platform so investors can see these standards in action. Avoid this trap by looking at all available options on loans.
The “Comfort Zone” Trap
Because of the risks involved in investing, investors may avoid investing in places or markets unfamiliar to them. While each investor has to make decisions that makes the most sense for their portfolios and financial situations, excluding entire markets simply due to a lack of experience in them may mean investors miss out on potentially profitable investment opportunities.
Additionally, investing in a diverse array of markets is another great way to diversify an investment portfolio to help hedge against risk. When investments are spread across locations rather than concentrated in one or two markets, the risk of losing money due to market fluctuations in a given area is mitigated. GROUNDFLOOR regularly updates the loans currently open for investing on the platform; as a result, there are always new and different investment opportunities to consider to help diversify your portfolio.
The “Urgency” Trap
While real estate markets are less volatile than stocks or the forex market, timing is also key in real estate investing. Keeping track of market and financial fluctuations should be part of every real estate investor’s routine, whether you are completing real estate projects yourself or just passively investing in them.
GROUNDFLOOR’s BRRR Loans (Buy, Renovate, Rent, Refinance) provide a convenient way for real estate investors who have acquired property but wish to await more favorable market conditions before flipping to complete their projects. These loans typically accommodate a longer loan term than the traditional hard money loans the company offers, resulting in more flexibility for the developer and thus reducing any perceived pressure around timing. Passive investors on the platform also benefit, as BRRR Loans offer yet another way to diversify active funds while also being a generally lower-risk investment option, as such loans are backed up by multiple underlying properties - namely, the rental units - rather than by just one.
Another way the urgency bias can appear is when considering whether or not to purchase an investment property. Real estate tends to move quickly, especially in rapidly expanding markets, and pressure to not miss out on a perceived great opportunity can sometimes cause real estate investors to make hasty purchases. GROUNDFLOOR’s new QC Maxx program provides developers with pre-approval for a business line of credit for their projects, so concerns about missing out due to funding delays or issues are lessened. This allows real estate investors to be rest assured that funding will be available when it’s needed, so they can focus more on carefully evaluating potential properties.
The “I Knew It” Trap
Perhaps the most dangerous on this list, hindsight bias keeps investors from learning from their mistakes. The “I knew it” attitude some investors have about every investment (win or loss) can hinder the ability to learn from past experiences.
A modified version of this cognitive bias, which Investopedia calls superiority bias, is where intelligent investors believe they know better than experts. GROUNDFLOOR’s proprietary grading algorithm that is qualified by the U.S. Securities & Exchange Commission saves investors from these biases through objective vetting. Evaluation reports are obtained through certified independent appraisals, brokers’ price opinions, and borrowers’ appraisal and comps. This raises investors’ confidence and, in turn, helps them make insightful and informed decisions with regards to how they can successfully handle their investments.
Amber Jane is a blogger with a passion for following property market trends. She hopes her articles will guide her readers through the maze that is buying or selling property and help them avoid any traps. In her free time she loves to dance.