February has been quite the month. Altus’s new (redeveloped) office building is still at least 4 – 6 months from being ready for occupancy so naturally our current landlord told us on February 3rd that he had sold the building and we had to be out of our offices by the end of the month. I had a close relative undergo major surgery for a life-threatening condition and on top of normal business operations, Altus spent the month raising money for our new Multi Tenant Income Fund (only 3 weeks left until funding closes!). The list goes on and on, including the reality that several of Altus’s flip markets have experienced a marked slowdown and in some cases falling prices. Oh, and there was a new addition to our family which severely impacted sleep.
As I sat down today to turn the thoughts captured in my notes into an article that would (hopefully) bring value to our distribution list, I received notice that we were losing a buyer from one of our sales escrows due to a financing issue. In my current state of quasi exhaustion (newborns can have this effect) this bit of bad news, even though normal in the course of doing business, was enough to cause discouragement. In returning to writing this article, the notes I had moments before been considering using went out the window and my thoughts became fixated on the psychology of investing.
I certainly don’t claim to be an expert on investing psychology, but it is an area that fascinates me. It is a topic rarely studied or understood by most investors but it may well be the single most important factor that determines an investor’s success in their investing efforts. For the purpose of this article I am going to include emotion as subsection of psychology.
Psychology plays into every investing decision we make and plays into our investing careers in two basic ways. The first is how we structure our investment strategies. The second pertains to the decisions we make to buy or sell assets within (or for that matter outside) of that investment structure.
For illustrative purposes I will use one of our investment strategies of flipping houses. Technically I would argue that flipping houses isn’t investing, it is trading (there are key differences), but in regards to our study of psychology it fits the purpose. We buy and sell lots of houses, mostly in the North Bay and Sacramento regions. The proceeds from those transactions are used to pay our business overhead and increase our available cash to invest in longer term positions.
We know that markets go up and down and we understand that forecasting the residential real estate market 3 – 6 months from the time we make our purchase is as futile as guessing whether the stock market is going to go up or down in three Tuesday’s time. The general direction of the market might be assumed, but the volatility within that trend is better off not guessed. As an aside, this is another reason we prefer long term investing strategies – the effects of volatility are minimized. This volatility is an accepted part of the strategy. But our strategy goes further. We focus on low to mid level houses for which there is a large resale market and we focus on risk mitigation mostly through purchase price. If our expected profit margin is large enough we can absorb a portion of a falling market without loss of investment principal. When the profit margins are large enough we will venture into homes above the median home price, but only when accompanied by large expected margins and never at the expense of a lower price point opportunity. Contrary to what may seem obvious, the best market for us to flip houses is not an appreciating market, it is a flat market. In a flat market we can most accurately determine our resale price and hold time, and with that information make more accurate investment decisions.
Unfortunately for us flat markets rarely exist, at least not for long. It was only a few months ago we heard the siren song of a $1.5 million 1700 sq ft flip purchase in a rapidly appreciating market that was expected to have close to a million dollars of profit over a 6 – 9 month period. This flip provided a percent of margin well above our minimum requirements and also provided an excellent return on the hours our staff would spend on the project. I am proud to say that after thousands of dollars and a substantial amount of time spent on due diligence we walked away. We walked not because the numbers didn’t work or weren’t verifiable but because we realized this purchase was outside of our strategy and our core competencies.
When we first developed our flip strategy we intentionally created it with the absence of emotion knowing the markets would go up and down, so we wanted to be at price points that would be the least painful in case of a market move to the downside. We also wanted to be at price points where if we drop the price low enough there will be buyers. That is not the case at all price points. Our strategy was developed so that if the markets did move against us we could sell out of our positions, take the reduced profits, or even losses, and then buy in again at the lower prices. This isn’t to minimize those principals who make huge amounts of money within the higher priced markets, it is just that it is not our expertise and we make a concerted effort to not chase the “bling” and take the disciplined, focused approach of a dependable, consistent, repeatable business model.
The aforementioned $1.5 million flip opportunity did not fit our strategy but was tempting to us because of the profit potential, the chance to “get rich”, to hit the home run instead of the single. It also could have been a catastrophic hit to our company had the market moved the wrong direction. How many investors fall into the trap of trying to get rich all at once and as a result end up wasting time that could have been used to produce return on their investment dollars, or worse yet, losing principal itself?
Today my psychology challenge was different. Today I wasn’t feeling like taking on the world, I was frankly feeling a little beat down. And while feeling beat down, an opportunity to purchase a house in Sacramento presented itself for review. Everything about the opportunity seemed to make sense. The returns hit the margins we require, the liquidity within the particular market is high, and better yet, the repairs required would be able to be completed within a relatively short amount of time. And yet I was apprehensive.
How does one tell the difference between a feeling of fear and a negative “gut feeling”? How does one’s current emotional or psychological state affect the decisions they make regarding their investments? Why is it that a market can spook and the stock darling of one day can be the disdained loser of the next day? Did the fundamentals of the company really change that much in a day? Why is it people are afraid to invest against the crowd? Why is it investors want to bring other investors into their investments to feel good about making that investment? Why is it people would rather be severely wrong as part of a crowd rather than moderately wrong on their own? Aren’t we all grown men and women that can make our own investment decisions?
The entire investment community is striving to obtain returns that beat the market. The market is by definition the average of all investment returns, so returns that beat the market are necessarily different than average. But how many of us are willing to do something different than everyone else to obtain those better returns? How many of us are willing to do something everyone else thinks is wrong? How many of us are willing to sell losses short against the prevailing wisdom of the day? How many of us are willing to admit mistakes and cut our losses, even at the expense of our pride? Maybe most importantly, how many of us are willing to stick with a long term strategy we believe to be sound just because of short term losses or decreases in price (volatility)? Again, how many of us truly are willing to be different to obtain the different returns required to beat the market?
These are all questions of investing psychology. I certainly don’t have all the answers but at Altus we strive to separate our personal emotions and psychological paradigms from the investing process as much as we possibly can. This starts first with an awareness of those emotions and paradigms. It includes involving more than one partner in the decision making process almost as a third party arbiter. It sometimes extends to sleepless nights spent pondering and dissecting the motivations behind decisions.
And we are buying the house.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at email@example.com.