We Are All Just Monkeys

In my post yesterday on technical indicators I hinted at my belief that we as humans need things like technical indicators to protect us from ourselves.  We are all emotional individuals and that emotion is usually detrimental to our success.  Barry Ritholtz, author of the Big Picture blog has a better way to say what I am alluding to.  This excerpt is from an interview that Barry did with Forbes.

Forbes: What is the greatest financial lesson you’ve ever learned?

Ritholtz: You’re a monkey. It all comes down to that. You are a slightly clever, pants-wearing primate. If you forget that you’re nothing more than a monkey who has been fashioned by eons on the plains, being chased by tigers, you shouldn’t invest. You have to be aware of how your own psychology effects what you do. This is why we as investors sell at the bottom, get panicked. All the other lessons I’ve learned have come out of that. As has the field of behavioral economics.

Wall Street clichés, like "cut your losses and let your winners run" come back to prevent the monkey part of your brain from doing what it does. There’s a banana–I want it. That’s how chimps behave. Us humans react to greed and fear in predictable ways. We are predictably irrational. If you understand that you can take steps to prevent that–we don’t own anything in the office that doesn’t have a stop-loss on it. In 2008, we watched the market go down 40%. We figured out we’re chimps, and don’t let the chimp inside us make those chimp-like decisions.

Every good financial decision I’ve made comes from, "Wait a second, monkey boy, step back, don’t do that." Once you realize how your own brain chemistry works against you, it gives you a chance to not panic at the bottom.

The really interesting thing is that Barry talks about his firm’s reliance on the stop loss order and how the use of stop losses helped save them when the market tanked in 2008.  Real estate not only has no version of the stop loss order, investments are far too illiquid to immediately liquidate, but real estate investing theory doesn’t even recognize the value of limiting your losses.

Tell me if this scenario sounds familiar.  Market is rising, investor is buying.  Market stops rising, investor is not worried.  He has income in place from the real estate.  Market starts falling, investor doesn’t think about selling.  He decides to wait it out for prices to come back.  That income is still in place.  Prices keep falling.  Tenants start to vacate.  Loans come due.  Investor can’t service the debt burden.  Investor loses the whole deal.

In the case above, the investor could have booked a small loss on his deal if he had sold it when the market first started falling.  Instead the investor chose to wait things out and in the process lost the entire investment.

It’s kind of odd that in real estate it is most common to see the following things:

• Small gains
• Large gains
• Huge losses

I’ve left out the possibility of small losses because when compared against the other three potential scenarios, small losses are a lot less common.

Real estate investors have no way to protect themselves if their bet as to market direction turns out to be wrong.  In fact, real estate investors largely miss the point that a falling market is feedback that your investment meme may have been off base.  In football if you are losing at halftime you make adjustments in the locker room.  If real estate investors are losing at halftime they often come out with the exact same game plan in the second half.