Recognizing Investment Pitfalls
Warren Buffett refers to these five words as the most dangerous for any entrepreneur or investor. Yet investors continue to ignore market fundamentals, deny their own logic, reluctantly investigate contrary ideas, focus on what others are investing in, and only listen to perspectives that confirm their initial beliefs. They fail to recognize that when they decide to buy, someone else has decided to sell, likely because the seller believes there is no more upside. By not following sound strategies and discipline, investors’ actions are similar to participating in the annual Running of the Bulls in Pamplona, Spain. And just like trying to outrun the bulls and follow the herd, some investors will be gored. Buffett's five words for investors to heed and avoid — “Everyone else is doing it.”
One of the hardest perspectives for investors to maintain is to be disciplined. This results from difficulty in separating emotion from the investment decision-making process. Emotions, such as fear of missing out (FOMO), become a visceral response, especially when business news reports and even our friends are touting the spectacular gains they have achieved by investing in the latest fad.
Peter DeMarzo and Ilan Kremer of Stanford University Graduate School of Business and Ron Kaniel of Duke University Fuqua School of Business authored a study about the key ingredients that lead to an investment bubble. Their research concluded that “when it comes to someone’s actual investment decisions, rational thought takes a back seat to what the peer group is doing.” Basically, “keeping up with Joneses” overrides fundamental research and logic analysis. The emphasis on the importance of wealth in determining social status becomes predominant. When investor’s make decisions based on perception that their peers are becoming wealthy, they don’t want to be left out, they make similar investing choices, and this produces herd mentality and a bubble.
Herd investing explains why bubbles develop when economic models indicate the opposite should occur. A recent example was the dot-com bubble. Stock market fundamentals dictate that an equity’s valuation should be based on its Price to Earnings ratio. However, at that time, most dot-coms weren’t producing any earnings. They did generate impressive quarter-over-quarter revenue growth, as well as significant website usage, and organic impressions. However, without earnings and the inability to generate sufficient revenue to cover their expenses, they required ongoing equity infusions, and corresponding stock valuation dilution. As we witnessed, companies such as Enron, WorldCom, and Global Crossing, who collectively generated over $81 billion in revenue in 1999, did not survive to December 2002.
When investors are not focused on applying fundamentals, objectivity, and discipline, they become highly susceptible to a psychological process called “Confirmation Bias.” In Robert Dobelli’s book “The Art of Thinking Clearly,” this concept is referred to as the mother of all biases because it refers to the tendency to only believe data points that support the initial hypothesis and ignore information that contradicts it.
Confirmation Bias then produces overconfidence. Aldous Huxley wrote, “Facts do not cease to exist because they are ignored.” Critical thinking is important to produce consistent positive investment returns.
Social media helps to promote and sustain Confirmation Bias. It learns preferences and directs searches towards information that are biased toward prior activity. This further reaffirms an investor’s initial ideas as opposed to providing differing viewpoints. Focusing on the positive reviews or number of likes can further enhance Confirmation Bias even though the actual sample population may be small.
Investors should focus on developing an investment hypothesis and then testing it objectively to confirm its validity. When Kenwood identifies a new real estate investment opportunity, we challenge our models’ assumptions and actively seek out independent opinions from various leasing agents, lenders and the market itself. For example, rental rate assumptions are tested against competitive projects. We evaluate the property’s proximity to highways, onsite and nearby amenities, construction quality, as well as overall design and space flexibility against its peers to ensure that rental rates are appropriate.
By not objectively testing and not listening to contrary viewpoints, investors can fall victim to Confirmation Bias, which ultimately leads to building an investment portfolio on an unstable foundation.
How to Avoid Herd Investing and Confirmation Bias
Some important and basic steps to follow to become a more engaged investor and avoid FOMO would include:
- Ignore the crowd, and practice sound discipline — Always follow market fundamentals. They are an important guide rail to keep perspective.
- Evaluate ideas rationally — Understand what you are investing in and why. Typically, something needs to occur for an investment to appreciate. Understand what this will be.
- Understand your financial objectives — why does this investment meet your goals, short vs. long term? Are you interested in growth or value? Value emphasizes regular cash distributions, while growth reinvests excess cash to produce more appreciation.
- Manage your emotions — When stocks are increasing, everyone wants to participate and when they are decreasing, investors remain on the sidelines. In fact, being a contrarian investor can produce very good results. Also, sometimes the best investments are the ones you didn’t pursue because you missed the initial increase and now there is more downside potential.
- Diversify your investments — Diversification is one of the most powerful investment strategies available. Broadening investments to multiple industries, adding non-correlated holdings, and mixing asset classes — stocks, bonds and real estate — can significantly enhance overall returns. More importantly, diversification offers investors a better risk/reward balance when compared to a more tightly focused investment strategy. The goal being how to produce the highest level of returns with the least risk.
I remember in 2007-2008 when real estate prices were rapidly increasing due to “Cap Rate Compression” and investment brokers would passionately explain to me, “Ignore the market fundamentals. Cap rates, historical prices per square foot and even Internal Rates of Return (IRR), didn’t matter anymore. It’s a new paradigm.” Hearing those words not only set off alarm bells in my head, but also reminded me of the importance of not following the herd, but being vigilantly disciplined, and testing every investment theory.
It's not easy to walk away from perceived opportunities. But one very valuable lesson that I’ve learned through the years as a real estate investor is to understand how we plan to create value. This could be accomplished by leasing vacant space, improving curb appeal, addressing deferred maintenance, or reducing operating expenses. Thoroughly evaluating all potential options and pitfalls has provided me with the systematic discipline needed to keep emotions, herd mentality, and Confirmation Bias out of Kenwood’s investment decision-making process.
Kenwood Management is always looking for new investors to join the Kenwood Community. Learn more about our investment services and how you can generate steady and secure commercial real estate gains with our team of experts.