The evidence for stockmarket investor bias is overwhelming. We are so not rational when it comes to our stocks that the thought that there are still researchers out there trying to develop theories based on the idea that we actually think through what we do is somewhat mindblowing.
However, you’d expect that if we’re strangely biased when it comes to financial transactions involving the stockmarket that we might also be a bit slanty-brained when it comes to other asset classes as well. And as real-estate is probably the biggest single investment any of us will ever make it’s probably a prime candidate for a bit of behavioral analysis.
The interaction between real-estate and other asset classes was well exemplified by the most recent bust, as poorly managed sub-prime mortgages fed through into the wider markets and economy resulting in an economic convulsion we’re still feeling the effects of. In fact since 1970 there have been around 25 booms and subsequent busts in developed economies, as discussed by Luca Agnello and Ludger Schuknecht in Booms and Busts in Housing Markets, who find that these movements are related to short-term interest rates, the general availability of credit and mortgage market deregulation. Basically if you make it easier to borrow people will, and all too often they’ll borrow more than they’re able to repay when times get a bit tougher.
This behaviour immediately signals that there are some underlying biases here – the lack of foresight in taking on debt at a stretch which you can’t repay when things get harder is a typical failure to discount the future properly, a tendency we’ve seen in reverse in retirement investing where people also fail to prepare for the future. Given this you’d expect that the literature would be full of evidence about the behavioral ineptitude of property investors but, in fact, it’s rather limited in this regard.
Losses in Helsinki
A couple of years back we looked at the history of property rights and the likely behavioral implications in Property Rights and Wrongs, and the more recent research suggests that the indications there were correct. The same behavioral flaws that impair our judgement on the question of stocks are equally relevant to real-estate pricing.
Mikko Einiö and Markku Kaustia in Price Setting and the Reluctance to Realize Losses in Apartment Markets have shown a range of peculiar things occurring in Finnish real-estate, over and about that nation’s peoples’ addiction to long summer holidays in cabins far out in their beautiful countryside. Amongst other things they suggest that the results are consistent with the unconscious application of our old friends loss aversion and mental accounting.
Loss aversion is perhaps the key behavioral bias of all – pretty much the original finding of the founding fathers of behavioral finance, Amos Tversky and Daniel Kahneman, was that people simply hate taking a loss. They’ll sell their winners to lock-in a gain, even if they’re selling something which will probably keep on going up (and by-and-large they do), and they’ll hold onto their losers in the hope of making back their gains (and by-and-large they don’t). Losses cause regret and hurt twice as much as gains, and avoiding them is a powerful instinct (see Loss Aversion Affects Tiger Woods, Too).
Round Numbers and Mental Accounts
Einiö and Kaustia make a number of interesting, and rather odd, observations: there are an inordinately large number of sales at zero capital gains, for instance, with the data suggesting that people are waiting long times to obtain their desired prices, suggesting that they’re very unwilling to realize a loss. There are also a large number of sales at gains of 25%, 33.3% and 50%, an indication perhaps of people locking in their gains or maybe the well known tendency of people to find round numbers highly salient (see: Irrational Numbers: Price Clustering and Stop Losses).
Mental accounting is another powerful behavioral bias, an idea proposed and popularized by Richard Thaler. The concept is simple – we tend to form separate mental accounts for our money which we then manage separately. We might, for instance, be better off taking a loss on our condo and investing it into the booming Mongolian stockmarket than hanging on and waiting to break-even and miss the emerging market opportunity of a lifetime. However, mental accounting mitigates against this, forcing us to hang on to our collapsing condo and meaning we lose out twice – once because we lose more on our property than we need to and a second time because we’ve lost our Far Eastern gains (see: Mental Accounting: Not All Money is Equal).
Disposed to Profit
Again the researchers suggest mental accounting may well be playing a part in their participant’s thought processes:
“We find that a large number of apartments are sold exactly at the purchase price. These zero-return observations form an important part of the general loss realization aversion pattern. The results are consistent with the idea that sellers are trying to break even in their mental accounting, framing the purchase as a gain or loss in relation to the original purchase price.”
The idea that mental accounting may be playing a big part in real-estate market variations is taken up by Michael Seiler, Vicky Seiler and Mark Lane in Mental Accounting and False Reference Points in Real-EstateInvestment Decision-Making. They find that the disposition effect – the name given to our greater willingness to sell at a profit than a loss – is indeed a powerful driver in the real-estate market (see: Disposed to Lose Money).
In particular the research shows a jump in the willingness to sell when a property moves into positive territory, which we’d expect given previous research in this area. Interestingly, though, this is an effect net of transaction fees – which suggests that people may be biased, but they’re not stupid.
All Mavened Up
Given that the evidence for these common behavioral biases seems to be quite strong in real-estate transactions we might also expect other familiar friends to appear when we start looking at the boom-bust behaviour of property markets. A likely suspect would be herding, the tendency of people to follow each other rather than thinking for themselves. In Mimetic Herding Behavior and the Decision to Strategically Default Michael Seiler, Mark Lane and David Harrison certainly seem to find evidence that the decision to post back the keys is linked to herding:
“We find that homeowners are easily persuaded to follow the herd and adopt a strategic default proclivity consistent with that of their peers. Herding behavior is stronger when a maven, or thought leader, is involved and weaker when the person finds strategic default to be morally objectionable.”
The invocation of Mimetics – the predisposition to learn by repeating observed behaviour – offers a explanation of why we abandon our own beliefs in order to follow someone else’s; it’s a biologically evolved response to situations of uncertainty. The ideas that a real-estate expert can influence default decisions and that the defence against it is dependent on feelings of moral obligations are both fascinating and worthy of more analysis. However, the overall finding that herding is a factor in real-estate behaviour, both for professionals and the rest of us, is both suggestive and indicative.
Of course, anyone who spends time looking at and thinking about behavioral bias can find it pretty much anywhere they look. That’s both a strength and a weakness, because anything that explains everything probably explains nothing. But if you do want a an explanation of why real-estate booms and busts get out of hand then starting with cheap money and adding a dose of behavioral economics will probably get you a long way.