An Anchoring bias or an Availability bias can cause you to overlook opportunities and lose money.
Investing is a numbers game. I meet new investors every day and most of them are good at numbers. They can keep their emotions at bay and make logical decisions. However, even seasoned professionals have blind spots. Expensive blind spots. Here is a true story of an investor (name has been changed) and how his blind spots prevented him from making the right decisions.
McDowell is a seasoned investor. He came to the office to discuss what he was looking for. The meeting began with a familiar refrain. He said, “The market is white-hot. It’s slim pickings for investors. I bought 12 deals in 2019, 7 deals in 2020, only three deals in 2021, and it looks like I won’t be able to buy even one in 2022.” I asked him about his deals, and he told me that he only bought flips. He had made an average profit of $50,000 on each of them. He stayed away from all other types of deals. He was a victim of the success trap. This happens to someone who has done something that worked but cannot duplicate the success anymore because the market has changed. He kept comparing the new deals to his previous ones, and he wasn’t finding spreads of $50,000 anymore. I probed deeper to understand his strategy and ROI. Here are the numbers on a typical deal he did
Purchase price = 250k
Rehab = 50k
Total cash needed = 300k
Selling price = 380k
Selling costs & holding costs = 30k
Therefore, Profit = 50k
ROI = 50k/300k = ~17% for 6 months = 34% per year.
I asked him if he had used lending for the deals he did or if he paid cash. He told me that he had used lending. Here were the numbers after factoring in the lending:
Purchase price = 250k
Rehab = 50k
Total cash needed = 300k
Loan amount = 250k
Cash-out of pocket = 50k
Selling price = 380k
Selling costs and holding costs = 30k
Interest + points = 17k
Loan principal = 250k
Therefore, Profit = 33k
ROI = 33k/50k = 66% for 6 months = 132% per year. {He was getting an ROI of 132% per year}
As he shared the numbers with me, I nodded my head in agreement. I could see that he knew what he was doing and had the experience to prove it. However, the inventory has been so tight that he could no longer find deals like these. He was frustrated and didn’t know what to do.
So I asked him the most logical question. “What’s your next option? If you can’t find the deals you’re looking for, where will you invest the money?”
He replied, “I’ll put it in the stock market and make 10% on it.”
I knew then that Carl was acting out of bias and not out of logic. What were his biases and how was he acting out on those? Let me explain.
Cognitive Bias
There it was—an investing blind spot. Carl had gone from an ROI of 132% down to 10%. No in-betweens. Many seasoned investors will relate to this. The ROI on the second-best option is miles away from the first option. This results from two cognitive biases: Anchoring Bias + Availability Bias.
Cognitive biases are blind spots in our thinking that cause poor choices. The way to avoid them is to be aware of them so that you can avoid the pitfalls they bring with them.
Anchoring Bias
Anchoring bias results from the first example: The first price you see will become your yardstick to judge all other prices after that. It is a pernicious bias routinely used on late-night infomercials on TV. It’s usually about a new kitchen product like a set of kitchen knives. The host says, “These knives are usually sold for $350! But if you order them now, you can get them for $99!”
Knives for $99 may not be a good deal, but it looks like a great deal because you subconsciously compare it to the anchor price of $350.
In the case of flipping homes, the Anchor profit set in Carl’s mind was $50,000. Any profit lower than that seemed like a bad deal.
Availability Bias
The other bias that adds fuel to the fire is the Availability bias. It is a mental shortcut that relies on immediate examples when evaluating whether or not something is a good deal. This is the most common of all cognitive biases. For instance, Plane crashes can cause people to feel afraid of flying even though dying in a car crash is far more likely. Statistically, it is 86 times more likely that a person will die in a car accident than in a plane crash.
In the case of flipping homes, the only examples that Carl could think of other than his own were flipping shows on TV where profits of $50,000 are expected.
What could Carl do to turn the situation around? Could I help him see his dilemma? I did. Here’s how:
Avoiding cognitive bias
To help Carl spot his cognitive biases, I asked him a series of questions:
“Okay, So Case 1 is you buying a flip to make $50,000 in 6 months.
Here is Case 2: What would you say to a deal in which you invest $50,000 to get $2,500 in 6 months?”
“It’s a terrible deal,” He said.
“Okay. Here is Case 3: Would you be open to buying a rental and get $250 per month?”
“No. I don’t think I would buy a rental. The return is too low compared to the flips.
“Okay. Here is Case 4: What would you say to a delayed flip in which you invest $50,000 to get $3000 every year for the next five years and another $50,000 on top at the end of 5 years?”
“I think I can do that one. Yes.
“Do you realize that Case 2, which you called a terrible deal, are you investing the money in the stock market at 10%, and Case 3 which you rejected is the same as Case 4, which you accepted? Furthermore, the rental has a higher return than the stock market based on the rent alone? With the rental, you would double your money in less than five years, whereas it would take you seven years to double your money in the stock market.
Carl was taken aback. He started scribbling the numbers on a piece of paper to make sure it wasn’t a trick. When he saw the numbers, he realized his blind spot. He selected the flips and the stock market because it was what he knew. His Anchoring Bias and Availability Bias led him down that road. He didn’t consider the rentals because he compared the return with flips. He didn’t compare rentals with the stock market. He also did not realize the vast gap between the ROIs on flips and the stock market.
The learning for Carl was not necessarily that he should buy rentals even though it’s the more prudent choice. The wisdom was to understand the influence of cognitive biases when making decisions.
Conclusion
Cognitive biases affect all of us. Any time that you’re making an investment decision, do this test to see if your decision is being influenced by the anchoring bias and the availability bias:
Write the numbers on a piece of paper and convert all the ROIs to annual numbers after adjusting for leverage so that you’re comparing apples to apples. Then choose the option with the highest return and act on it. This way, you’ll be able to avoid stepping on dollars to chase pennies.
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