How can you know if a financial move is a good one? A poor investment selection would entail what? Is the decision itself the defining factor of the outcome, or does the outcome, in turn, define the decision? Rather than making an excellent investment decision that results in a loss, would you rather make a terrible investment decision that results in a profit? This question is not rhetorical, despite what you may be thinking.
We, humans, are irrational entities that justify our choices with reasoning. Most of our choices are determined subconsciously in the reptilian brain, which controls our “fight or flight” responses. They are then rationalized in the neocortex, which controls our higher-order thinking processes. The reptilian brain is more frequently stimulated than the neocortex, which drives choice. Human bias originates in the reptile brain and can only be contained via rigorous techniques centered on the objective presentation of data.
Before looking at the numbers, most real estate investors would rather put their money into a shiny new high rise than an old run-down apartment complex. That’s because our reptilian brain’s emotional responses allow us to make hasty judgments and because our brains are hardwired to find cute things that flash and glint in the light. The neocortex is responsible for providing a justification for these choices after the fact, but the relevant data has been willfully ignored by that time. Often, we form opinions without consciously intending to do so.
Here’s why that’s significant:
The choices we make always have consequences. This concept is known as the anticipated return in the world of finance. As investors, we expect to be fairly compensated for the risk we incur when investing. To a reasonable degree of certainty, I would wager those five out of every ten times I flipped a coin, half of the outcomes would be heading, and the other half would be tails. However, the actual outcome of an investment is sometimes very different from what we expected, and we may therefore experience a wide range of emotions around the intended outcome.
Maybe eight out of 10 times you flip a coin, you get heads, and only two times you get tails. Continue to toss the coin until the law of large numbers takes effect. The good odds are that if I flip a coin a thousand times, I will get an even split between heads and tails. This idea has been instrumental in developing gambling establishments everywhere and can be utilized successfully in the financial markets.
A decision’s quality is determined by the likelihood of its consequence rather than the actual result. For example, an investment in the S&P 500 would be a solid choice if you could fairly expect a positive return on your money eight times out of 10. As a counterargument, it’s never a good idea to take your life savings and travel to Las Vegas to play blackjack in the hopes of doubling your money.
Investing is about stacking the deck in your favor to reap long-term rewards. While it would be nice to believe that good judgments always have positive results and bad ones always have negative ones, the reality is more nuanced. Risky conduct can pay off financially in the stock market, while safe, steady investment strategies can backfire and cost money. Our inherent biases influence our decisions, and a successful outcome can reinforce the decision-making process. We tend to believe that repeating a successful move will yield the same result as we were just lucky the first time.
Matrix of Choices and Their Potential Related Outcomes
The four quadrants of the following matrix depict the expected results from various choices. Every investor has dabbled in all four, but the most successful (and aspiring) investors should concentrate their efforts in the fourth quadrant. Since the probability of long-term success increases with the number of smart judgments made, this is the quadrant that will provide the highest riches.
Let’s take a good, long look at each of these to see what it would be like to work in each of them.
Quadrant #1: Wrong Choice, Unfavorable Consequences
This quadrant is known as the ‘What was I thinking?’ quadrant. The beneficial lessons are also known as the learning quadrant, which can cost more than an MBA. A wrong decision leads to bad consequences in this region.
If you’ve been investing for any time, you’ve probably done business in this area. Deals like these are the ones that pop out at you and sound exciting. Perhaps you gambled on a penny stock, put money into a company that went bankrupt, invested in a real estate developer, or put money into a company that makes high-end socks because of the promise of a 40 percent return. Making these blunders at the start of your investing career is beneficial because the risks are low, but you should move on from this area as soon as feasible. It is how we grow as investors via trial and error.
The failure to invest is another example of a poor choice. Great investments are hard to come by, and selling them off can be emotionally taxing, especially if the proceeds are then put into a venture that turns out to be less successful. Again, the odds of success or failure are what count. Many good real estate opportunities that people at passed on turned out to be good investments, but they wouldn’t change their minds if they had the chance to do it all over again.
For instance, the risk/reward ratio is poor if you invest with an inexperienced and undercapitalized operator in a frontier market, and the operator demands half the profits. The deals we didn’t take advantage of for the wrong reasons also led to unpleasant learning experiences. Because there are no do-overs in investing, we must learn from our mistakes and use them the next time we encounter a similar scenario.
Quadrant #2: Positive Choice, Unfavorable Outcome
What went wrong is the focus of this section. You consider alternative courses of action and conclude that you could have made a better choice, but ultimately you realize that you still would have chosen the same one given the same set of facts. You would have come out ahead in eight out of ten situations, but not this time.
Any ship, can crash in this sector. We bought a student housing complex in Tallahassee, Florida, in 2011. Also, we saved 40% on the original asking price because of its convenient location, free sizable parking garage, and low purchase price. The combination of these factors made it an attractive financial investment. After a year, we found that our operational partner could not deal with the resulting supply problems, decreased school enrolment, and falling rental rates. Every concern we had turned out to be justified. After 14 months, we decided to call it quits and sell the property.
Over the next decade, the Fund plans to purchase hundreds of properties. Thus the company’s decision-making process must be as efficient as possible. If they give something away for the right reasons, they won’t regret it afterward. These drawbacks could include excessive leverage, a lack of experience on the partner’s side, challenges that were too difficult to resolve, a subpar physical location, or intractable concerns.
Quadrant #3: Poor Choice, Positive Outcome
That’s the most hazardous section right there. Spending significant time in this region increases the likelihood that you will one day speak those dreaded five words: “I used to be rich.” As Bill Gates so eloquently put it, success is a poor educator. Intelligent individuals are fooled into thinking they have nothing to lose by this.
The investor in this third quadrant fared better than the lucky guy in the first quadrant, who lost money while making a poor choice. When we experience pleasure from an action, we tend to engage in that activity again and increase the stakes. This investor feels encouraged by the result instead of learning a lesson and breaking the cycle of making poor investing decisions. They fail to see that their choice will result in a financial loss in eight out of ten cases.
All of us have heard the tragic tale of a wealthy individual who lost everything due to their careless financial choices. Due to such investments’ emotional pull, it’s too easy to get stuck in the doomed upper right corner. Who wouldn’t want the chance to become a millionaire ten times over, to have their private island, or to be a part of the hottest new social media app? The fear of losing out on the next big thing is a powerful motivation that may easily sway choices and drain resources.
There is a plethora of education in this section. It would be best if you put your pride aside. Being aware of your ignorance is the first step to learning. It is important not to risk everything on a single venture. Also, spending good money on bad investments is a bad idea. Have some of your investments in different types of things. Only one time being wealthy is sufficient.
Curt Schilling’s demise as an investor is often cited as an extreme case of ill-advisedness. Curt was a pitching superstar in Major League Baseball and will be inducted into the hall of fame. He lost about $90 million of his fortune founding a video game firm that went bankrupt. His early achievements in baseball convinced Curt that he would not fail in any other business venture.
Quadrant #4: Excellent Choice; Positive Outcome
It is the area that everyone agrees is the most ideal for vacationing. There’s nothing more satisfying than realizing your expectations after making a conscious choice. The most common complaint about this diagram section is that it is uninteresting. The reptile brain struggles to process dull feelings. However, the greatest method to ensure long-term prosperity is to diversify your portfolio and gain 7% annually.
How likely your savings be worth eight times as much in 30 years as they are right now? Is this something you could accept? While most people will say yes, their subsequent investment behavior often has little to do with their stated goals. Considering the power of compounding, an annual return of 7% over 30 years would result in an eightfold increase in your initial investment.
We can find numerous relevant examples in the provided portfolios. The company’s mission is to always be in this region. Their decision-making procedure is under regular scrutiny, and they always look for ways to improve it. They consider the deals they passed on, assess the successes and failures of the ones they did, and utilize this information to guide their future decisions. To be sure, they won’t obtain 100% accuracy, but they should get quite close.
Moreover, they make choices outside of commercial transactions as well. They make all of their decisions about who to hire, allocating resources, seeking investments, and whether or not to invest in real estate to improve the company’s performance.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.