Published December 27, 2009

Investors give us a lot of reasons for not investing today. This video rattles off a long list of both positive and negative trends in the Puget sound region's apartment market.

On the negative side

Among other things, there are still a lot of new units poised to begin lease-up in 2010; vacancies are high and moving higher; rents will decline more next year; and net operating income will continue to slide.

On the positive side

Among other things, new construction will virtually halt in 2011; capitalization rates have lowered values by about 25%; job growth will start again in 2010, fueling net in-migration; and the number of young people in the 20-34 age group should grow dramatically over the next five years, fueling apartment demand.

So what should investors do?

Is this the time to buy, or does it make more sense to sit on the sidelines a while longer? This article continues where the video left off, by looking at three ways investors can come up with flawed conclusions when thinking about their investment options.

We think the real reason many investors are negative about the market right now boils down to some unintended biases in their decision-making process. We just read a good book, Nudge, by Richard Thaler and Cass Sunstein. It’s all about how people systematically go wrong by making decisions based on their experiences.

Among other things, the authors talk about biases that creep into our experience-based problem solving that can lead to bad decisions. Biased assessments of risk can perversely influence how we make business and investment decisions.

Anchoring bias

Anchoring is a bias where we underestimate the upside when we are in a down market, and vice versa. We’ve seen it often over the past 30+ years. When the market is strong, investors expect low vacancies and high rent growth, forever. When the market is in the tank, it’s hard for investors to visualize even a "normal" vacancy rate or moderate rent growth, let alone very low vacancies and significant rent increases.

Availability bias

Availability is a bias where we place more importance on events that are the most recent. We bet a lot of investors rushed out to buy earthquake insurance in the year after the 2001 Nisqually earthquake. It’s also a good bet that many have not renewed that insurance in the last year or two.

The event has faded from memory. It is no longer "available." Investors have been struggling with a tough rental market for a year now. Our natural availability bias makes us pay more attention to the market we are in right now, not the one we were in before, or the one we will be in tomorrow.

That leads to overly conservative decisions in this market, and it would have resulted in a lot of overly optimistic decisions a couple of years ago. We’re not suggesting investors be optimistic, just realistic. So when considering hold/buy decisions, think about how your biases are interpreting the information. Decisions can be improved if judgments can avoid these biases, and be nudged back in the direction of true probabilities.

Framing bias

Framing is a bias that plays on our natural risk aversion. People hate losses. Roughly speaking, losing $100 makes you twice as miserable as gaining $100 makes you happy. People are naturally loss averse.

Loss aversion helps produce inertia, meaning a strong desire to stick with your current investments, real estate or whatever. If you are reluctant to swap one type of investment for another, such as cash for real estate, because you don’t want to risk incurring losses, then you will turn down trades you might have otherwise made. So the framing bias comes into play in the way you place risk versus reward opportunities in your decision options.

The bottom line

We’re not suggesting investors ignore reality and embrace unbridled optimism. In fact, carefully working through these three biases will help investors avoid both unrealistic optimism as well as unrealistic pessimism. Some people tout "thinking out of the box." That's not really critical, and it's harder to do than it sounds. But at the very least, you should toss your anchoring, availability, and framing biases out of the box.

Editor's note: This is the complete article.

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