In this six-part series, we’ve been going through behavioral economics. Behavioral Economics is the study of what really drives how we make our decisions. When it comes to economic decisions, how do we decide what to buy, what to sell, how to build a portfolio? Now, why is this important? Well, it’s important for syndicators and fund managers and businesses, because that’s the basis of how a lot of our decisions get made. It’s part of our underwriting, this stuff that’s working in the background.
We went over the cognitive reasons in our last few videos, those things that are errors in judgment and where those come from. In this video and the following, we’re going to talk about the six emotional biases that start to drive in the background of our emotional decision making. These are the things that are weighing beneath the surface that could drive our decision and underwriting just way off. So let’s go ahead and get started with the first three.
Here are the six emotional biases. Today’s video, we’re going to talk just about these first three, and go through what exactly they are, what they mean to you.
The first one is the real biggie, actually. It’s called loss aversion. It is the fixation on the avoidance of a loss. I’ll give a personal story that will provide a good example. In about 1999, I bought into a lot of stocks. I figured I was a really good stock trader and was doing really well. Now, little did I know that in the back of my mind was this loss avoidance, loss aversion problem.
Hidden back there was this belief that I couldn’t take a loss, that everything had to come up. So when a stock went down, rather than sell it, what I would do is hold on to it, thinking surely it’s coming up. Now if you know what was happening during 1999, things were starting to implode pretty badly. We had almost reached the top. 2000 happened, and then after 2000, things went downhill pretty quickly.
I was well invested. I had things all across the technology sector, which was great up until 1999. Come 2000 February-ish, probably, things started to take a loss. One of my assets that I invested really heavily in and still believe in today was Webvan. I put dollar after dollar after dollar in Webvan, buying stock, buying and buying and buying it.
Webvan had a great idea: a grocery delivery service. It really was good. They had a huge network that they had built out. Unfortunately, they had grown too quickly, and they couldn’t service anything. So the stock around that time, around February of 2000, started tanking and started tanking a lot. But what did I do? Well, surely it’s going to come up, right? Surely it’s going to come up, it’s got so much value, it’s going to come back up. I can’t sell it because it’s going to go back up.
Even when it was worth half of what I paid for it, the writing was looking like it was on the wall for Webvan. It looked like it was gonna go belly up. I couldn’t sell it because I couldn’t stand for the loss. Because it was such a good product, it was such a good idea, and it was so well put together. It really had everything going for it. Except it didn’t. The market didn’t buy it. It wasn’t what was valuable at the time. It wasn’t believed that it was going to be successful.
But my loss aversion was unwilling to take a loss on Webvan. What happened to Webvan? Bankruptcy. Now worth zero. I’ve got thousands of shares in a company that doesn’t exist anymore called Webvan. That is loss aversion.
So it is the fixation on avoidance of loss. It’s irrational. It’s accounting for sunk costs, is how I like to think of it. So it’s, “Well, I already put all this money into it, and so surely it’s got to come up.” Well, those days were already gone, so I could have taken the loss and then moved on and put it into something that would be more profitable, but I didn’t. I counted on, “It’s just got to come up because I can’t lose on Webvan.”
Endowment bias is a little bit different. Endowment is the feeling it’s worth more because you own it.
Where I see this play out most of the time as a syndication and fund attorney is where you have a fund where they are preceding something with assets. So the fund is preceding it with assets. And they have this belief that since it came in in the beginning, this is really the powerhouse of it. This is what made them successful. And they’ve endowed these assets with magical powers. They’ve endowed this as the cause of their success. And so therefore, nothing can be done in order to sell this.
I see this all the time. This is the endowment bias. So it’s that feeling it’s worth more or the cause of their success because it’s already owned, and it was responsible for maybe their success up until a certain point, but then it could be a big, negative detriment.
You could even think of it not even as a specific asset, but even an asset class. So a lot of people think, “Well, I’m a multifamily guy, because I started in multifamily. And it’s been the cause of all my success.” Well, that’s great. But there might be other asset classes that would be even better for you.
I think multifamily is great. But I think there are also a lot of other asset classes that are even better. Of course, deal by deal, there are certainly going to be multifamily assets that are truly stellar, absolutely solid, and they should be invested into. But it doesn’t mean that all multifamily products are great, because they’re not. Most of them aren’t. But there are a number that are. But there are also a number of other asset classes that are also great. So that’s endowment.
The last one we’re going to talk about today is self-control. Now, it’s an illusion of self-control. The way this mostly comes about for syndications or in funds is having insufficient reserves. Reserves are necessary to make the expenditures to protect the investment itself, to protect the whole syndication or the fund for whatever may come up. Of course, it’s reserves and savings to make sure that you can cover those things without having to do a capital call.
Well, a lot of funds, especially, get that pressure to buy more and more assets. And so they don’t want their investment reserves to be too high. They also want to buy more, and so they lack the self-control to identify, “Okay, we need to really find the best assets and if it’s not there, maybe we do a distribution, or maybe it’s something else.” But the biggest cause, the biggest problem I see, is insufficient reserves.
Also, if it is this pressure to buy too much or outside of the fit. A fit, of course, is founder investment theory, buying outside of what you normally would because you’ve got this pool of cash, you need to spend it, you need to grow the fund. I know that pressure, I felt it myself. It’s there. And so you get this pressure to buy whatever it is, or even if it’s not even in a fund context, you need to put another syndication together. You’ve got all these investors who are clamoring for it.
You lack the control under this bias. It’s that lack of control of waiting until there’s the best asset for you. So making the investment kind of stilted, saying, “Oh, this is what we should invest in,” because you’re feeling that pressure and you don’t have the control in order to manage it and just say, “It’s just not the right time, the asset’s not there.” So that’s the bias of self-control.
And when I say you, I don’t mean you necessarily have that. But a lot of us do. I certainly do. I felt that pressure in finding the right assets to do. Fortunately, I’ve been able to control it, and I always invested in very good things. But, you know, maybe it is something that I actually have to think about, like when I’m underwriting. Am I doing this because the numbers are really there, or is something pushing me to do this when I just feel that pressure?
So it’s a natural thing, which leads me to why we do this, why we talk about these behavioral economics biases. It’s because there are those pressures there. You know, we make money as syndicators and fund managers by buying stuff, by running these things. And so you feel a lot of pressures. And there are a lot of pressures there that may shape that underwriting, which is bad for investors and bad for our investment business and bad for our syndication business. Because it makes us invest in things that shouldn’t be invested in. And it may make us blind to things that are better investments that are out there.
The whole point of why we’re even talking about behavioral economics is to help you see what the different things are that are just going on beneath the surface. I mean, this is all iceberg stuff, you know. These are the things you’re aware of. But down here, there’s all this other stuff. And that’s what needs to be combatted. So that way, when decisions are made, it’s because all these are good things. If we can lower the water, we can make decisions based on more thorough analysis of more facts. And then there’s still some things that are always going to be here beneath the surface. That’s why we do it.
My name is Tilden Moschetti. I am a syndication attorney for the Moschetti Syndication Law Group. We help syndicators and fund managers and businesses raise money by putting their documents together for them, and also offering advice and expertise in putting those syndications, funds, business capital raises together for Regulation D, Rule 506(b) and Rule 506(c) offerings.
Of course, I also have another hat, which is doing my own syndications, my own funds, and raising money for my own businesses. So I have expertise, both real-world just like you. And I’ve experienced all these kinds of behavioral economics issues in that role. That’s one of our unique propositions for why we’re such a great firm: we have the experience and the legal expertise, but also that real-world experience. I’ve been in your shoes before, so I know what the different pressures are and I know what it’s like to raise money. So that’s what we do. If we can help you, don’t hesitate to give us a call.