What Real Estate Investors Can Learn From the Irrational Brain

Topic:  • By David Scherer • January 25, 2017 Views

Michael Lewis’ latest book is not about financial markets, but real estate investors will want to read it. The Undoing Project gives them a smart way to thrive despite the market’s foibles.

The author of The Big Short and Moneyball is one of our most perceptive observers of market psychology. “Look at the market for baseball players,” he told Origin investors at a Chicago event this past fall. “The problem wasn’t information. There was plenty of information available. The problem was what the market did with the information, what the MIND does with the information.”

I wrote about Lewis’ lessons for real estate investors from the Chicago Cubs’ 2016 World Series run on TheStreet.com. But he reveals much more about the quirks of market behavior in The Undoing Project. The book recounts the collaboration of two academics — Daniel Kahneman and Amos Tversky — who laid the foundation of behavioral economics, a principle that applies psychological observations and insights to human behavior as a way of explaining economic decision-making. The team found that markets behave irrationally because people behave irrationally.

Lewis told the Origin audience “the brain actually does things that are contrary to efficiency. … it doesn’t make accurate probability judgments in uncertain situations, and this leads to mistakes in people’s decisions and mistakes in the market’s decisions.” As The New Yorker’s put it in reviewing The Undoing Project, “errors are not only common but also predictable.”

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This creates opportunities for the disciplined real estate investor, who can find value where the market doesn’t. Those who, like me, worked their way through Kahneman’s hefty Thinking Fast and Slow will recognize the behavioral economics concepts, but they’re also recurring themes in Lewis’ financial best sellers like Liar’s Poker and Flash Boys. “Markets are not inefficient just because people are inadequate,” Lewis said. “Markets can be made inefficient by just bad incentives being baked into them.”

Real estate investors can benefit from Lewis’ three key insights on behavioral economics:

1. Filter out the noise. As the more humble of the two researchers notes the New York Times, Kahneman came to question his results with small groups of experimental subjects. That led to his findings on judgmental bias — that the brain makes generalizations based on only a few points of data.

Our intuition is always working, and it’s primed to look for patterns — even if the evidence doesn’t support them. A sound business plan relies on a wide range of information, from detailed statistical analysis to “boots on the ground” observation, to validate where intuition leads us.

2. Be bold. The unorthodox heroes of The Big Short profited from knowing how banks had been rewarded for shaky subprime mortgages. “The information was available for a two-bit hedge fund manager in San Jose to figure out the whole market was screwed up,” Lewis told us. “But the market did not behave efficiently with that information.”

Like many of Lewis’ characters, Tversky had faith in his deliberative skills that allowed him to challenge conventional thinking. Real estate investors who take on solvable problems will thrive in both buyer’s markets and seller’s markets.

3. Put risks in their place. Tversky and Kahneman proved the brain is biased toward the sure thing, because the pain of loss is greater than the satisfaction of an equivalent gain. That means real estate investors who accept downside risk — who don’t overreact to small or random setbacks — are likely to reap a superior long-term reward.

Lewis could have scored a big advance for The Undoing Project, but he works under a different business model: He splits costs and profits with his publisher instead. “You should have the risk and you should enjoy the reward,” he says. That’s good advice for any real estate investor.

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David Scherer

David Scherer formed Origin Investments in 2007, along with co-founder Michael Episcope. He has over 20 years of experience in real estate investing, finance, development and asset management.