Nick Armet, an investment director at the British Fidelity Worldwide, writes about intangibles in markets.
One of the most interesting asset classes where we see pronounced influence of behavioral biases is in real estate.
Real estate is a highly emotive asset in most cultures. This can help explain phases of ‘irrational exuberance’ in property markets where prices move away from fundamentals.
Real estate markets suffer from a greater degree of incomplete information. No two assets are the same, and there is often no central exchange. Sellers tend to know more about assets than buyers, a fact that real estate intermediaries can exploit. The quality of, and access to, information is poorer than in stock markets.
Related to this point, subjectivity tends to play a much more influential role in the operation of the real estate market than in other more information-efficient markets.
Other studies provide show sharp appreciations in property prices are, at least, in part due to over-optimistic expectations. Models of economic fundamentals explain only between 10% and 40% of changes in property prices.
Real estate prices can be very volatile and not fully explained by fundamentals. The behavior of investors and real estate market participants themselves is the issue. Research suggests real estate markets show a wide range of behavioral biases.
Herding and group-think can both explain why pricing moves away from fundamentals. Herding can encourage over-investment in certain markets and sectors.
Despite the fact that real estate is an asset class which demands a long-term perspective, investors show a repeated bias towards fast and short -term return.
When herding combines with loss aversion, we can see some of the most disastrous consequences in real estate due to the illiquid nature of the asset class. Real estate investors are highly sensitive to capital loss.
We know that generally, losses are felt as least twice deeply as gains.
Status Quo Bias
Despite this predictability, most investors are caught off guard by market cycles. Real estate prices rise, oftentimes very quickly, and then the bubble bursts, leaving everyone surprised because of status quo bias.
We tend to think things are likely to remain the same: because our most recent memory is of them being a certain way. Investors buy real estate in hot markets because they expect it to continue going up. Investors expect this because the market has recently been rising. Status quo bias helps them to forget about cycles.
Investors fall victim to status quo bias because they believe the four most dangerous words in investing: “This time it’s different.”
Of course, nothing is different. The cycle always prevails, the bubble bursts and prices fall.
The best way to beat status quo bias is to procrastinate.
We all have emotional responses we don’t fully recognize when it comes to investing our money. Even the savviest investors sometimes give in to their emotions. Before you make another real estate investment, stop and make sure your emotions aren’t costing you money.
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This article is based upon Flex MLS reporting, legal opinions, current practices and my personal experiences in the Puerto Vallarta-Bahia de Banderas areas. I recommend that each potential buyer or seller of Mexican real estate conduct his own due diligence and review. If you have any other questions, contact me through my website.Harriet Murray