Point of View Cognitive Risk and Real Estate Portfolio Management

by Larry E. Wofford* Michael L. Troilo** Andrew D. Dorchester***

Real estate portfolio management often appears to deal almost exclusively with the application of rigorous statistical and mathematical techniques to develop, revise, and optimize real estate portfolios. A cursory examination of almost any issue of the Journal of Real Estate Portfolio Management conrms this casual empiricism. Underlying the applications of these techniques is access to large quantities of data, some publicly available and some proprietary. Because of the focus on these quantitative approaches using readily available hard data, real estate portfolio management has the appearance of being essentially objective in nature. Often overlooked is the notion that this objective analysis occurs within a broader context of overall portfolio management. Such overall management involves developing and communicating strategy, developing systems and networks to monitor portfolio performance, team development and interaction, and overall corporate culture, among other attributes. Many aspects of this broader picture of real estate portfolio management have signicant elements that do not generally fall into the objective classication. These less objective elements include, but are not limited to: Internal and systems. external communications

* University of Tulsa, Tulsa, OK 74104 or larry-wofford@ utulsa.edu. ** University of Tulsa, Tulsa, OK 74104 or mike-troilo@ utulsa.edu. *** Cushman & Wakeeld, Washington, DC 20006 or andrew.dorchester@cushwake.com.

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Larry E. Wofford, Michael L. Troilo, and Andrew D. Dorchester

Portfolio monitoring, dashboard design, and implementation along with the detection of weak signals of change. Analysis and effective communication of economic, nancial, social, cultural, technological, and other external factors. Information systems and accessibility. Group dynamics at all levels. Corporate culture. Each of these elements is critical to the overall success of the real estate portfolio management enterprise. Further, each element involves extensive human cognition and human interaction embedded within complex, dynamic, uncertain, and, often, ambiguous networks and systems. Thus, at a macro level, real estate portfolio management is not the purely mechanistic, algorithmically driven objective enterprise that it may, at rst glance, appear to be. Critical statistical and mathematical portfolio analyses are components of an overarching framework developed and managed within strategies, tactics, processes, systems, networks, goals, and objectives that are the products of individual and collective human cognition and interaction. These more or less subjective cognitive artifacts create the instrumental environment in which the structured objective quantitative analysis is framed, directed, performed, and evaluated. The subjective elements can signicantly enhance or reduce the real or perceived effectiveness of the quantitative analysis and overall portfolio performance. Even though the objective element of portfolio management performs well, given its instrumental mission, the real or perceived outcomes can vary signicantly. The potential variation created by subjective cognitive processes produces added risk for the portfolio management effort. Given its source, this risk can be labeled cognitive risk.1 Cognitive risk is particularly pernicious because it has not been explicitly identied as a risk factor and, therefore, it has not been considered as an important element of overall real estate portfolio risk management. Given its potential signicance to real estate portfolio management, simply ignoring cognitive risk is not a viable option as its identication also raises the question: To what extent
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can cognitive risk be managed? The simple answer is that, like most explicit risks, cognitive risk can be managed to some degree, but not eliminated. However, a cognitive risk management framework provides the opportunity to develop a better understanding of human cognition. This understanding will come from research into human cognition using the broadest possible set of disciplines.

Research into Human Cognition

Prior the 1950s, behaviorism viewed the human mind as a black box and research concentrated on stimulus and response. By the mid-1950s, some researchers began to view the mind as an active entity worthy of research into how it processes information. This cognitive approach is exemplied by Herbert Simons (1955) article, A Behavioral Model of Rational Choice. Simons article was followed a year later by George Millers (1956) classic paper, The Magical Number Seven Plus or Minus Two: Some Limits on Our Capacity for Processing Information, in which he documented that human working memory can process only about seven chunks of information at one time. Simon later developed the notion of bounded rationality to represent the fact that human cognitive abilities are limited in important ways and when faced with overwhelming amounts of data, these limitations can have signicant impacts on the output of human cognitive processes.2 Since Simon (1955) and Miller (1956), the theme of limited human cognitive resources coping with an environment with virtually unlimited information and exhibiting the characteristics of complexity, dynamism, uncertainty, and ambiguity has been prominent. Kahneman, Tversky, and Slovic, and other researchers, working primarily in cognitive psychology, found that humans use mental shortcuts manifested as biases and heuristics as data reduction efforts in order to cope effectively with limited cognitive capacities.3 These coping mechanisms create tendencies to classify and generalize, causing much information and many options to be ignored and real-world cognitive outcomes to deviate from those predicted by perfect rationality. Further cognitive research indicates

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that deviations from rationality often exhibit a systematic component, giving hope to the goal of developing approaches to managing such deviations and their impact. In the 1970s and 1980s, behavioral research rst migrated from cognitive psychology to economics and then to nance and real estate. In real estate, Ratcliff (1972) advocated understanding the behavior of market participants while Wofford (1985) outlined the impact of cognitive processes on real estate investment decisions. Diazs (1990) initiated an empirical research effort in behavioral real estate. Over the last two decades there has been a significant and growing interest in behavioral issues affecting economics, nance, and real estate. Behavioral research in economics and nance has evaluated the reasons and extent to which decisions deviate from rational choice theory and the instrumental rationality assumed in economic decision theory. The result has been a spate of academic articles and academic and popular press books dealing with what is often labeled as behavioral economics, nance, and real estate.4 This work has primarily, but not exclusively, dealt with research in cognitive psychology and has produced some very interesting and useful insights. However, this research effort has not explicitly identied cognitive risk as an entity or its management as a research target. Over time, cognitive research extended beyond cognitive psychology to a broader research umbrella subsumed under the heading of cognitive science. Gardner (1985) describes cognitive science as an interdisciplinary enterprise that includes work in philosophy, linguistics, anthropology, neuroscience, and articial intelligence. As Gardner (1985) emphasizes, it is not just the unique and insular research areas that are of interest, it is also the interrelationships between them that is critical for knowledge growth. Although not explicitly identifying and addressing cognitive risk, much of this research has produced general insights with real potential to be useful for understanding and managing cognitive risk. Many cognitive research ndings have been found to be robust across a wide range of human activity.

Unless one is willing to assume that real estate portfolio managers have cognitive abilities and characteristics that differ in signicant ways from the remainder of the human population, general cognitive science research should be of keen interest to real estate portfolio management.

Expanded Cognitive Research

While the disciplines and elds comprising cognitive science introduce new questions, theories, and methodologies useful for examining cognitive risk management, even this framework is not expansive enough. Simply developing a better understanding of human cognition and the many ways it contributes to the variability of outcomes and the resultant risk is an important, but incomplete, cognitive risk management research program. Among many other disciplines relevant to managing cognitive risk are communications theory, organizational theory and design, strategic planning, enterprise risk management, networks, systems, human error and failure, ergonomics, high reliability organizations, and even the study of time. This list is not intended to be exhaustive but, rather, suggestive of useful disciplines and subdisciplines. Individually and collectively, these research areas have the potential to make signicant contributions to understanding, identifying, and mitigating cognitive risk. They also have the potential to contribute to the development of resiliency from deviations, or failures, resulting from cognitive origins. A survey of the possible contributions from each of these areas is beyond the scope of this paper; however, we suggest that an array of disciplines, broader in scope than initially supposed, contributes to understanding and managing cognitive risk.5

Cognitive Risk Management Essentials: Mitigation and Resilience

Real estate portfolio managers practice risk mitigation to minimize the number and severity of errors and failures. However, these mitigation defenses cannot be totally effective and attention also must be given to mindfulness, failure detection,
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Larry E. Wofford, Michael L. Troilo, and Andrew D. Dorchester

correction, recovery, and learning. These activities determine the resiliency of an individual or organization when an unexpected negative event occurs. Resiliency involves being prepared to identify a failure and make corrections in a timely manner. Mitigation and resiliency together move an organization toward becoming a high reliability organization (HRO) (Weick and Sutcliffe, 2007).6 Weick and Sutcliffe (2007) have identied mindfulness, the ability to notice nascent problems and correct the situation before it becomes a problem of consequence, as a primary characteristic of HROs. They further identify the ve principles that dene HROs: (1) Preoccupation with Failure; (2) Reluctance to Simplify; (3) Sensitivity to Operations; (4) Commitment to Resilience; and (5) Deference to Expertise. The rst three principles address mitigation by helping HROs maintain mindfulness and pay attention to weak signals while the last two principles involve resiliency, the HROs ability to contain and recover from the problem. In short, adherence to these principles helps to create a robust, resilient organization in environments that are essentially unstable in part because of cognitive factors (Hollnagel, Woods, and Leveson, 2006). Real estate portfolio management operates in such an environment. The HRO approach is anticipatory in a very shortterm, in-the-moment manner, not anticipatory in a strategic sense. It also does not work to solve past problems: the focus is on the future. In this sense HROs are proactive, not reactive. Collins (2009) takes the opposite approach by addressing how successful enterprises fall into oblivion and/or bankruptcy. He develops a ve-stage model to describe enterprise decline: Stage 1: Hubris Born of Success; Stage 2: Undisciplined Pursuit of More; Stage 3: Denial of Risk and Peril; Stage 4: Grasping for Salvation; and Stage 5: Capitulation to Irrelevance or Death. Collins (2009) contends that past success does not guarantee future success and may create an arrogant attitude of infallibility that leads to what is essentially selfinicted failure. When the stages of decline and related behaviors identied by Collins (2009) are compared with the
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principles of HROs outlined by Weick and Sutcliffe (2007), the cognitive differences between successful and unsuccessful organizations are clear. Collins (2009) essentially outlines an enterprise that thinks it knows it all, pursues opportunities recklessly, fails to pay attention because of the incorrect notion that it is invincible, discovers its vulnerability too late and, ultimately, perishes or becomes irrelevant. In contrast, HROs are characterized by a need to always learn more about operations, a signicant recognition of risk from even the smallest events, a detailed plan for recovery, and a commitment to resilience. The distinction between these two lists of behaviors, all with cognitive roots, could not be sharper. An air of infallibility and inattentiveness mark failure while mindfulness, an awareness of vulnerability, and resilience are the hallmarks of sustained success.7

Moving Forward
Real estate portfolio management can benet from an awareness and better understanding of the cognitive elements affecting portfolio performance. Human cognition has been researched within the context of cognitive science, but many other disciplines also provide vital insights useful for understanding and managing cognitive risk in the real world. Understanding cognitive risk and its management will require an interdisciplinary, integrative synthesis, concentrating not only on distinct disciplines, but a true understanding of how those elds interact. Real estate portfolio managers who address cognitive risk and its mitigation have the potential for signicant improvement in overall real estate portfolio performance. With appropriate effort, these managers can drive real estate portfolio management entities towards becoming highly reliable organizations.

Endnotes
1. For a more detailed discussion of cognitive risk in real estate, see Wofford, Troilo, and Dorchester (2010). 2. For discussions of bounded rationality, see Simon (1979, 1990). The 1979 paper is Simons Nobel Prize in Economics acceptance speech. For another perspective on the value of the concept of bounded rationality, see Gigerenzer and Selten (2002). 3. Cognitive psychology research on these topics is extensive. Original articles such as and Lindblom (1959), Kahneman,

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Slovic, and Tversky (1982), and Kahneman, and Tversky (1990) provide useful insights. Useful collections of articles and original papers are to be found in Kahneman, Tversky, and Slovic (1982), Arkes and Hammond (1986), Zey (1992), and Kahneman and Tversky (2000). Evans (1989) provides a very succinct and readable discussion of bias in human reasoning. A very readable, useful, and early application of cognitive psychology to economics is supplied by Maital (1982). 4. Examples of these books include Irrational Exuberance (Shiller, 2000), Mean Markets and Lizard Brains (Burnham, 2005), Your Money and Your Brain (Zweig, 2007), and Predictably Irrational (Ariely, 2008). Other books in the same vein include Shefrin (2000), Akerlof and Shiller (2009), and Fox (2009). 5. For a more extensive discussion of these elds see Wofford, Troilo, and Dorchester (2010). 6. Both mitigation and resilience are not without problems. Mitigating a problem may mask bigger issues that ultimately may produce even bigger problems later. 7. Likewise, resilience may not be the best course of action if the costs are too high or long-term prospects do not justify continuing. But mitigation and resilience are effective risk management tools when utilized intelligently. Gardner, H. The Minds New Science. New York: Basic Books, 1985. Gigerenzer, G. and R. Selten (eds.). Bounded Rationality. Cambridge: MIT Press, 2002. Hollnagel, E., D.D. Woods, and N. Leveson. Resilience Engineering. Hampshire: Ashgate, 2006. Kahneman, D., P. Slovic, and A. Tversky. Judgment Under Uncertainty: Heuristics and Biases. Cambridge: Cambridge University Press, 1982. Kahneman, D. and A. Tversky. Choices, Values, and Frames, Cambridge: Cambridge University Press, 2000. Lindblom, C.E. The Science of Muddling Through. Public Administration Review, 1959, Spring, 7988. Maital, S. Minds, Markets, & Money. New York: Basic Books, 1982. Miller, G.A. The Magical Number Seven, Plus or Minus Two: Some Limits on Our Capacity for Processing Information. Psychological Review, 1956, 63, 8197. Ratcliff, R.U. Valuation for Real Estate Decisions. Santa Cruz: Democrat Press, 1972. Shefrin, H. Beyond Greed and Fear. Boston: Harvard University Press, 2000. Shiller, R.J. Irrational Exuberance. Princeton: Princeton University Press, 2000.

References
Akerlof, G.A. and R.J. Shiller. Animal Spirits. Princeton: Princeton University Press, 2009. Ariely, D. Predictably Irrational. New York: HarperCollins, 2008. Arkes, H.R. and K.R. Hammond. Judgment and Decision Making: An Interdisciplinary Reader. Cambridge: Cambridge University Press, 1986. Burnham, T. Mean Markets and Lizard Brains. New York: Wiley, 2005. Collins, J. How the Mighty Fall. New York: HarperCollins, 2009. Diaz, III, J. How Appraisers Do Their Work: A Test of the Appraisal Process and the Development of a Descriptive Model. Journal of Real Estate Research, 1990, 5:1, 115. Evans, J. Bias in Human Reasoning: Causes and Consequences. East Sussex: Lawrence Erlbaum Associates Ltd., 1989. Fox, J. The Myth of the Rational Market. New York: HarperCollins, 2009.

Simon, H.A. A Behavioral Model of Rational Choice. Quarterly Journal of Economics, 1955, 69, 99118. . Rational Decision Making in Business Organizations. American Economic Review, 1979, 69, 493513. . Bounded Rationality. In J. Eatwell, M. Milgate, and P. Newman (eds.), The New Palgrave: Utility and Probability. New York: Norton, 1990. Weick, K.E. and K.M. Sutcliffe. Managing the Unexpected: Assuring High Performance in an Age of Complexity. Second edition. San Francisco: Jossey-Bass, 2007. Wofford, L.E. Cognitive Processes as Determinants of Real Estate Investment Decisions. Appraisal Journal, 1985, 53, 388 95. Wofford, L.E., Troilo, M.L., and A.D. Dorchester. Managing Cognitive Risk in Real Estate. Journal of Property Research, 2010, 27:3, 26987. Zey, M. Decision Making: Alternatives to Rational Choice Models. Newbury Park: Sage, 1992. Zweig, J. Your Money and Your Brain, New York: Simon & Schuster, 2007.

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