Investors Therapy #13: Known knowns and unknown unknowns


Hey investors!

Occasionally I’m asked, “Where do you think the real estate market is going?” No one knows with certainty. If we had absolute certainty there wouldn’t be such a thing as a risk because all investments would be correctly priced. That’s why my lunatic detector goes on high alert when I hear people talk with certainty. Written in our DNA is our need to feel secure and sadly that need compels us to listen to charlatans that claim to have all the answers. 

Once you become certain about investment ideas, you build a wall around your brain which prevents new information from reaching you resulting in knowledge entropy—the killer of wisdom, portfolios, and societies. There are very few things to be certain about in life, taxes might not be an issue anymore if you can escape to Mars and death might go to the wayside if bio science has anything to say about it. What I am certain of is our innate ability to trick ourselves into believing we aren’t susceptible to investment killing psychological traps, hence the name “Investors Therapy.” 😉

When it pertains to investing, I think about odds. What are the odds of my bet coming true?

For determinate games such as poker it’s possible to determine the odds of an event happening because all variables are known (there are 52 cards in a standard deck of playing cards), which allows savvy poker players to calculate the odds of their hand winning. But don’t confuse probability with certainty. If you made a decision to raise your bet but you ended up losing the hand to a royal flush, you at least understood the odds were in your favor, but of course that doesn’t guarantee you will win.

You can be right with your assessment, but the problem lies when will the market agree with you?

That’s why I preach to investors you must be prepared to be wrong. You can’t pick a financial all-in strategy, you have to reserve a degree of uncertainty. You have to make sure the bet you’re making won’t knock you out of the investment game. When you start thinking in terms or all or nothing, that’s when you can lose a fortune. Think in terms of becoming a perennial investor, an investor that thrives through multiple market cycles.

What about the real estate market?

The longest economic expansion in US history lasted for 120 months from March 1991 to March 2001. Our current economic expansion has been going on for 116 months. We had one of the largest financial crashes in modern American economic history in 2007. The crash resulted in a significant expansion of the federal reserve’s balance sheetto the tune of 4.5 Trillion dollars. So how much more steam does this bull run have? Who knows. Some are saying this economy still has steam, and others think its time to prepare for a pullback.

What about indeterminate games?

As Donald Rumsfeld once said:“…there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

When I first heard this quote I laughed, but then as I grew older I laughed at myself for not grasping the message. As with indeterminate games, there are “known-knowns,” but then there are the dreaded “unknown-unknowns” that can wreak havoc on your plans. The problem with markets is you have an unlimited amount of unknown-unknowns that create feedback loops off each other, you don’t know how those variables will react with one another, and more importantly, you don’t know how others will respond to those variables. 

Let’s say your bet is right, you now have to determine the impossible, when will the market come to its senses? I remember a stock analyst that called the first tech bubble. He was labeled as a crackpot because the rest of the market had financial incentives to continue with its insanity. He wouldn’t be vindicated for another 5 years, but the problem is what if he went all in and started shorting stocks (a strategy to make money off of a stock when the price drops) 5 years too early? The losses would be catastrophic.

Let’s not forget about the gold investors that hoarded their assets in precious metals because they feared the collapse of the US dollar back in 2008. Most governments will fall into some sort of debt crisis leading to currency devaluation. The US has defaulted on its debts in 1779, 1862, 1933, and 1971. But when will the next one hit? Unfortunately, the all-in gold investors missed out on a fantastic equity bull run from 2010-2017. Eventually, the gold investors will be proven right, but when will that happen? Well, due to the way our government is spending, maybe the default will happen sooner than we think.

Most Gurus and syndicators are singing songs to people on how the hefty real estate returns post-crash will continue in perpetuity. They are doing a great job spinning this message because their investment funds are now oversubscribed by money hungry investors. No one wants to say they missed out on the real estate boom between 2010-2015 so the fear of missing out is coursing through our veins. There’s a reason why you’re seeing more gurus advertising their boot camps. When deals dry up they need to find another way to monetize. They monetize by selling people on a dream of investing. They collect nice guru boot camp fees. While new investors buy terrible deals, Gurus accumulate a cash pile for a real estate pullback. Once the market contracts and people grow tired of real estate, the gurus buy as many properties as they can to lock in above average market returns, and then they start the cycle over again.

Those of us who cringe at certainty, realize that market cycles can strike back with a vengeance. Real estate’s strength and weakness is the fact that it’s tied to reality through affordability. At some point, consumers are unable to keep up with rent increases or their mortgage payments. Banks become unwilling to loan investors money for sky-high valuations. So when we see a drop in home affordabilityfalling commercial cap ratesmortgage debt build up, and signs of lenders tightening their requirements that could mean the market is cooling off. But, with consumer debt service ratios in good shape, who knows if this is just seasonal or the signs of deeper contraction? Maybe we are heading towards a soft slow down like we saw in 1994. And in some markets we are seeing consumers flush with cash coming off the sidelines to scoop up properties.

Historical Returns

Since around 2012 inflation adjusted total returns for residential real estate (appreciation + rental income) have been about 17% per year, but if you look at the historical averages since the 1950s inflation adjusted total return in real estate has been 8%. Will real estate continue to reward investors with a nine percentage point premium over its historical yearly average? Probably not.

After the recent crash investors were buying undervalued properties that were charging tenants below average rents. Once unemployment fell, property valuations increased and rent yields rose resulting in healthy returns. Currently, investors are paying premiums for real estate. They are not paying based on the current income potential of real estate, they are buying on the hopes of an even brighter future that unemployment will go lower and wages will continue to surge without causing inflation and rate increases – a big bet.

When these bets are made, the margin of safety (rents – operating costs & financing = margin of safety) shrinks, leaving investors exposed during a recession. As my day would say investors are “betting on the come.” Which means investors are hoping lady luck with bail them out for paying market premiums for inflated asset prices.

As I mentioned in my new years day post: “Investments go through seasons (a time to plant, a time to nurture, a time to harvest, and a time to do nothing). If you lose sight of the seasons and you plant when the season is asking you to harvest, you will find yourself in a world of hurt.


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