Even the most experienced real estate investors make some common behavioral bias mistakes. These mistakes are almost always reactions high-stress situations, which often result in powerful emotions overtaking one’s logical decision-making process.
- The denomination effect causes investors to buy properties without fully analyzing ROI potential
- Loss aversion often causes investors to hold onto properties too long
- Status quo bias causes investors to avoid change, even when necessary
Real estate investing can be an incredibly stressful and emotional process. There will always be ups and downs, and market cycles will always catch some investors by surprise. As a result, every real estate investor will fall victim to behavioral bias at one point in time, and they may not even realize it. Here are Value Walk’s top three behavioral bias mistakes and how to deal with them:
Denomination Effect – Most people are hesitant to break a $100 bill for something that costs $30, but they do not hesitate to spend three $10 bills. That hesitancy to spent larger bills is a great example of the denomination effect, which causes real estate investors to buy cheap homes without considering exact costs of renovation.
To avoid the denomination effect, seek detailed and realistic valuations for any potential investments. Plan out exactly what needs fixing, estimated costs of any renovations, and time involved to make the property livable.
Loss Aversion – It is a common mistake for investors to hold onto property after prices drop, even if the market is not likely to bounce back anytime soon. Research has shown that for most people, the pain of losing is stronger than the joy of winning. So, some investors will make decisions based on avoiding the pain from losing, even if the odds are in favor of winning.
Selling a property for a loss and investing that money elsewhere could be the most profitable decision. The Overnight Test is a simple way to decide if you should sell for a loss, according to Value Walk. Imagine you went to sleep and the asset was replaced with cash overnight. Would you buy that property at the current market price – or invest elsewhere? In that hypothetical, if you would not buy your own asset, you should probably sell for a loss.
Status Quo Bias – Market cycles are a part of every single investment opportunity. For some reason, there are always investors caught off-guard when market cycles repeat themselves. This feeling is the result of status quo bias – the tendency to think things are likely to remain the same.
If real estate prices have been rising non-stop for years, it is time to consider a potential drop-off. In Hong Kong, for example, residential real estate prices more than doubled between 2009 and 2015. By February 2016, however, prices had fallen an average 10%, and sales fell 70% compared to a year earlier.
It is hard to go against the status quo, but there are still ways to avoid it. Behavioral economics has shown that people are more likely to make the change, and go against the status quo if they take a full week or more to consider the decision. If forced to decide by the end of the day, people are more likely to leave things unchanged, Value Walk reports.