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."
While the endowment effect is a clear problem for homeowners, it can also apply to investors. You will find many real-estate investors who will express love for their own investment properties. Further, people will also develop attachments to non-physical assets like stocks.
"In equities, people are often buying stock in the companies they work for to the exclusion of other companies because they think 'this is a great company,' and that's not a good strategy at all," says Harvard Business School professor Michael Norton. "You see the same thing in housing, you believe that your house is a great house even though the foundation is crumbling and you will invest more money to fix your home rather than sell it and move to a new house."
Putting good money into a property that would be better off sold exemplifies how the endowment effect can result in bad investment decisions. It also demonstrates the difficulty people have in recognizing or accepting "sunk costs," or expenses that have already been incurred and are unrecoverable.
The principal of sunk costs is well established and featured prominently in financing and accounting courses well before the psychological basis for it was explored. Large enterprises and individual consumers both fall victim to it by pouring money into unrecoverable investments and compounding losses. It is known as the "Concorde effect" after the money-losing supersonic plane which was completed in spite of financial overruns and a known inability for cost recovery. It is also known as the fallacy of the "money pit," a term that became the title of a 1980's Tom Hanks comedy about a couple who kept sinking costs into home repairs.
"Sweat equity" and the IKEA effect: A downside to DIY
Most homes aren't "money pits," and investing in a property through renovations is usually a proven route to building value. However, investing in renovations can also increase the endowment effect and distort a homeowner's or investor's ability to valuate a property. A Harvard Business School (HBS) paper by Norton, Duke's Ariely and Daniel Mochon of Yale, describes what they have dubbed "the IKEA effect": people have a strong tendency to overvalue things on which they have contributed labour, whether it be flat-packed IKEA furniture, origami or a home.
"We asked novices to fold origami, and gave other people origami that we had made by origami experts," says Norton, briefly describing one of their experiments. "Even though the origami made by experts looked really beautiful and was objectively better, we found that people would pay just as much for their own lousy creations as they would have paid for those made by experts. And, they thought that other people would also pay a lot for theirs, as well. It's not just that we value things that we make more than we should, but we also think that everyone else thinks they are beautiful."
For investors, one takeaway from this is to remember that while home renovations can increase value, they may not increase it by as much as the person renovating the property may imagine. Homeowners or investors who take a hands-on, do-it-yourself, approach to renovations, may especially have a propensity to overvalue their contributions.
"From our experiments, we see that the harder it is to make something or finish a product, the more you will overvalue it. The more 'sweat equity' you put into something, not only the more will you value it but you also think that for some reason other people will like it," says Norton. "Why anyone would care how much you sweat over the product is unclear, but we believe that somehow a person will overvalue something because of the amount of labour we have put into it."
Valuing a job done poorly; discounting one done well
This leads to a further oddity is that the more amateur a person's efforts – the longer it takes them to finish a job – the more likely they are to overestimate the value their work compared to a skilled professional. "When people get very good at making something they will value it less highly, not because the thing is any worse – and in fact it's probably better because they're become better at making it – but because they haven't put as much labour into it, they therefore think other people won't value it as highly," Norton notes.
While behavourial economics can measure how people's labour results in an exaggerated sense of valuation, Norton notes that people also overestimate their own good taste. This is conventional wisdom and successful realtors, home stagers and investors will all note that properties should be "depersonalized" before a sale (that a fuchsia kitchen, for example, would look better in a neutral colour). Norton advises that sprucing up a property before attempting a sale can enhance market value, but putting work into personalization may distort a seller's valuation.
"When people put effort in themselves, when they are out there and slaving over landscaping, they believe that it will provide value for a buyer. They believe that the more of their own work they put into sprucing it up, the more the buyer will value the house," he says. "That doesn't make much sense: if the buyer likes the house, the buyer likes the house and, if anything, if you're making it idiosyncratically match your preferences, you are making it less likely to be valued by a buyer who will have to come in a repaint all the walls because you've painted them a horrible colour."
Anchoring: Mental prices aren't market prices
Few people go into a marketplace blind with no sense of the price of goods or services, especially for large purchases such as property. People establish reference prices, or anchors, on which to base their buying or selling decisions. At its most basic, this means looking at the market and establishing reference prices based upon actual conditions. But because people also develop their own anchors based upon personal experiences or on completely irrelevant information.
"Conventional economic theories say that people know how to value objects and services, but one of the big findings of behavioural economics is that that is the furthest thing from the truth," says Rotman's Soman. "What people do is look at the market price, they anchor on that and then they adjust, but when there's no clear market price, people will tend to anchor on absolutely irrelevant things and start adjusting."
People will base anchors upon their personal tastes and experience – such as setting a price based upon the endowment effect or the amount of "sweat equity" employed in renovations – and on information that strikes them as being of key importance (such as purchase price or peak-market high). After these personal reference points are established, people will not easily abandon them for new anchors based on current market information.
"Reference prices are quite important for both buyers and sellers. What people paid for their home is their reference for their minimum selling price, but a potential buyer could not care less about that price," says Norton. "Especially in a downmarket, using reference points is problematic because sellers will feel they are being cheated."
Sellers aren't the only ones who make costly mistakes, and irrelevant anchoring can lead people to make poor decisions on the buying side. "In Toronto we have people moving in from different parts of the country or different parts of the world, and they will bring in their own anchors. Moving from New York City, these anchors are set higher than Toronto," says Rotman's Somon. "People who move from 'point A' to 'point B' tend to use the anchors that they have established in their home towns which could lead them to either underbid or overbid."
This tendency was measured by Wharton's Uri Simonshon and Carnegie Mellon University's George Loewenstein. Using data from 928 movers and their rental choices, they found that renters coming from more expensive cities will initially rent units in their new cities at rates that are above market prices. They will subsequently move to lower-rent units as they establish a new "framing" for what fair prices should be.
Investors should also be aware that also likely have similar biases when looking at properties that are outside their familiar home markets. While a three-bedroom condo in Detroit may seem cheap when viewed by an investor from Vancouver, property and rental prices are driven by local market conditions. Without a local framing reference, gained through experience or research, an investor may be more likely to make a bad purchase decision or miss out on a great deal.
Fooled by numbers
Another problem for buyers is an inability to conceptualize the significance of numbers as scale increases. If one candy bar costs $1 and another costs $2, all things being equal a person will buy the $1 bar and possibly be outraged at the markup. If a television costs $500 but the same model can be bought 10 kilometres away for $400, most people will make the drive… but they won't likely feel the same grievance about the $100 markup as they would about the $1 one.
As numbers grow, people will lose their initiative to seek bargains. If a furniture set costs $5,300 at a nearby outlet and $5,200 at an outlet 10 km away, people will be much less inclined to make the drive, even though the savings is the same as they would receive for the television. People will not put in the same amount of effort to save the same amount of money.
For big-purchases like housing, blindness to the meaning of numbers becomes magnified. "If you were buying homes and one home is $1-million on a home and another one is $1,010,000 it feels as though that were exactly the same price," says Harvard's Norton. "When numbers get so large, people become very insensitive to changes. They will go with their gut and think 'we are already spending hundreds of thousands of dollars so what's another $10,000?'"
The way the human mind processes large numbers has other unexpected effects. One example comes from a study on home offer pricing by University of Florida professor Chris Janiszewski and research assistant Dan Uy. Looking at five years of data, they found that sellers who set relatively precise listing prices, ending in $100 or $1,000 increments, had closed sales at amounts that were closer to their initial offers than sellers who set less-precise initial asking prices, ending in increments of $10,000 or $100,000. By establishing more precise anchors through their offer prices, sellers were able to secure a higher floor on price negotiations.
Pulling up anchors: The importance of refreshing your views
While investors may have a better sense of market prices than homeowners, it doesn't necessarily mean that the most experienced participants will automatically have a clearer idea of market pricing. Because price anchors tend to be reinforced over time, a long-active investor may develop entrenched views, especially if they were established over a period where there has been market stability or a consistent trend. A new participant may take a fresh view and set reference points based on current conditions.
"If I have been a buyer who has been bidding on houses for the past two years, I will have my established anchors and I may stick to those old anchors," said Rotman's Soman. "But if I am a first-time buyer or someone who someone has just started looking after seven years, I will have to start working with the current data as opposed to my historic beliefs, and I will be establishing my anchors."
Market booms and busts
Behavioural economists have been eroding the long dominance of "efficient market" theorists for several decades, and at an accelerated pace since the 2008 financial crisis when financial models seemed to fail tragically. But in spite of the insights it offers on human behaviour, it does not make predictions that can help us forecast booms, busts or the long-term price direction for real estate markets.
Nevertheless, by expanding our knowledge of human behaviour and enlightening us to our own biases, it may help us be more rational market participants and bring us one step closer to becoming homo economicus.
"At the end of the day, the way you frame a purchase decision can change t he way you will value a property: if you frame as an investment as opposed to framing it as a home. The moment you frame something as an investment, you become closer to thinking about the property the same way an average Joe will think of it," says Rotman's Soman.
From Canadian Real Estate Wealth Magazine, a monthly publication focused on building value through property investment, covering topics such as values and trends, mortgages, investment strategies, surveys of regional markets and general tips for buyers and sellers.