This is the second part of cognitive biases. We’re going to go through three more cognitive biases. This is part three of a six-part series on behavioral finance. Why are we talking about behavioral finance? Because behavioral finance shapes what we do as fund managers and syndicators. The assets that we acquire and the analysis that we go through get swayed by our own natural behavioral psychology. We’re not purely rational decision-makers as much as we want to be. In this series, we’re going to talk about the second set of three cognitive biases. In the next video, we’ll talk about the last three, and then we’ll start talking about emotional biases.
In our first video, we talked about behavioral finance. In our last video, we began talking about cognitive biases. Let’s switch to the whiteboard and see where we’re at. Here are the biases. Last time, we talked about conservatism, confirmation, and control. This time, we are going to talk about representativeness, hindsight, and framing. Our next video will go through anchoring, mental accounting, and availability.
Let’s go through representativeness, hindsight, and framing. What are those and what’s going on? Representativeness is the idea that the past will repeat itself. It’s a false belief that the past always repeats itself.
This is why when you look at the website for any kind of investment, you’ll often see “past results do not indicate what’s going to happen in the future.” Because what happened in the past doesn’t always repeat itself. We certainly have events that change things radically, market forces are changing, and we have black swan events. This causes investors to invest in hot investments. You’ll see massive trends towards certain things. Right now, self-storage is really hot, so people are flocking to self-storage. Next, it might be data warehousing facilities. Whatever it is, it causes people to see great returns and think, “Okay, that’s the next great return.”
One example I often saw was in Los Angeles, where people would constantly talk about why to invest in multifamily. They would say the market always increases multifamily at a much greater pace than rent growth. Rent growth is about 2% or 3%, but the appreciation on properties always appreciates up 5%. That is a pure example of representativeness. It may have been a historical trend, but it doesn’t foretell what’s going to actually happen. At some point, it’s going to change.
Hindsight is always 20/20. That’s exactly what this means. It could be that your investors say, “You are the best syndicator in the world, we always make 30% IRR.” And they might say, “I knew it going in. I knew we were going to make 30%. I know that you were saying it was 20%, but I knew it was going to be 30%.” That’s an example of hindsight bias. It’s saying that the future was predicted, or that the current state was predicted, when you didn’t know it before. This creates a false sense of confidence and decreases the perceived risk of what’s going to happen.
The third one is called framing. Framing is the tendency to interpret information not based on the pure information itself, but based on its source and presentation. Let’s say you have two opportunities you’re looking at. One hired the best marketing team in the world. It looks so great. The brochure is amazing with 3D photos and a video player that opens up. They hired James Earl Jones to do the voiceover. It’s great. The other one looks like it’s been written in crayon. You might automatically decide to adopt the first one because it looks better. But the information may have been way better in the second one.
Framing is that bias where we choose to gravitate towards something based on how it’s presented, rather than looking beneath the surface at the actual information being portrayed. We need to consider how reliable the information is, not just the package it comes in.
My name is Tilden Moschetti. I’m a syndication attorney for the Moschetti Syndication Law Group. I’m also a syndicator and a fund manager just like you. Part of what I bring to my practice is the legal documents, but I’m also putting together this video because, as a syndicator and fund manager, I understand the issues you’re going through. These ideas of behavioral finance absolutely come up. I know because they come up for me, and if they come up for me, I’m certain that they come up for you.
I thought it would be helpful for us to work together and define what these biases are so that we can stomp them out. Ultimately, we take control and mitigate the damage caused by these emotional and cognitive biases. In the end, our investors get better results, you get better results. It’s a win-win across the board. Again, my name is Tilden Moschetti, Moschetti Syndication Law Group.