The following article is from Canadian Real Estate Wealth Magazine.
In classical economics it’s assumed that humans are self-interested actors who can make rational decisions toward their own goals. No economist would argue that homo economicus, economically rational man, exists in reality; they know that humans are emotional, have biases, act on bad information and make poor decisions. Still, in order to make predictions or policies, efficient-market theories assume that people on the whole will act in rational and predictable ways in order to improve their material well-being.
This view has been challenged by the relatively new field of behavioural economics, which looks at the ways people, both individually and collectively, often have a propensity toward economically irrational behaviour. In many cases, behaviouralists have shown that irrationality is the rule rather than the exception; people are not merely irrational but they are, as Duke University professor Dan Ariely titled his best-selling book, “Predictably Irrational.”
Through lab experiments and market analysis, behavioural economics has produced considerable research into the psychology of pricing, shining a light on common blind-spots and biases that can hamper a sale or lead to costly mistakes. Among their most well-established findings: people have a strong tendency to establish mental prices that don’t reflect market prices, people have deep trouble cutting losses, people will almost always overvalue objects that they own and, especially, the value of their own labour.
A good way to overcome irrationality, enabling you to make better investment decisions, is by being self aware and understanding how common biases arise. Here are some of the most common cognitive traps that afflict homeowners and investors alike.
Loss aversion is a common psychological barrier that deters sales and prevents people from realizing losses. Research has shown that people are more strongly inclined to avoid losses than they are to seek gains. The emotional “pain” people experience from a loss is mentally greater than the benefit a person feels from an equivalent gain. The concept was demonstrated by Nobel-prize winning economist Daniel Kahneman and his late collaborator Amos Tversky, pioneers in behavioural economics who are often regarded as the discipline’s founders.
In markets, loss aversion can come into play when people are unwilling to sell an asset at a price for less than they paid for it. Distaste for losses means that people will often hold on to an asset – such as property or stocks – even if it seems highly likely that it will depreciate further. This effect is well-established in equities. To compensate for losses in a portfolio, investors will prematurely cash-out gaining stocks to make up for for losses in assets that they continue to hold, hoping that these will eventually break even.
The endowment effect: Overvaluing what you own
Homeowners may be even more susceptible to loss aversion than other property investors due to an emotional attachment to their homes. Research on the Boston condo market by economists David Genesove, of Hebrew University of Jerusalem, and Christopher Mayer of the University, of Pennsylvania ‘s Wharton School, found that that homeowners are likely to suffer much sharper losses than investors who own but do not occupy a property... often twice as large.
While there are many reasons why a homeowner would be resistant to sell, such as cash concerns or the work required for a household move, Genesove and Mayer speculated that the psychological pain of selling one’s own home at a loss is greater than that of selling a pure investment property. This is what behavioural economists’ refer to as “the endowment effect.” Essentially, people are strongly inclined to assign a higher value to things that they themselves own than they would to identical items in the market.
“The endowment effect is that when you hold on to something it becomes more valuable to you,” says Dilip Soman, professor of marketing and Corus Chair in Communications Strategy at the University of Toronto’s Rotman School of Management. “It accounts for a lot of the gap in [perceived] value between a buyer and seller. If I lived in a house for five years there will be a lot of latent factors about the house that I can articulate – the ease at which a screen door opens – but that a buyer may not appreciate.”