Behavioural Biases explain why people overpay for houses even when the housing market is in a clear bubble
After a historical run-up in housing prices in Canada and clear evidence that the Canadian housing market is in a bubble, I am amazed that Canadians continue to purchase real estate as an investment, while shunning investing in stocks (especially when stocks are still very attractive by historical standards). This is in the face of evidence that Vancouver is now the second most expensive housing market according to the 8th Annual Demographia International Housing Affordability Survey: 2012. Even though there is strong historical evidence that renting and investing the difference in a well-managed stock portfolio has been a far superior investment choice to owning real estate over the past 30 years, Canadians still prefer investing in real estate over building a well-managed, diversified stock portfolio to fund their retirement.
Reasons for these investment choices all fall under the discipline of behavioural finance, which is a discipline that studies “psychology-based theories to explain stock market anomalies” and investor behaviour. Behavioural finance “seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.”
While many concepts or behaviours contribute to irrational investment decisions, below are the concepts that I believe have the greatest effect in causing investors to favour purchasing more expensive real estate over owning historically inexpensive stocks.
Anchoring is a concept whereby an investor bases a decision on irrelevant data. For example, a recent high in a stock price or housing prices may tempt an investor to buy more stock or purchase a bigger house because prices went up. The same goes for a temporary drop in price when viewed as a buying opportunity not based on the fundamental value of the investment but merely on price movement. In the case of housing, investors want to buy more because prices have continued to go up. In the case of stocks, which have performed poorly relative to housing, the anchoring bias states that they are not a good investment so investors sell their stocks in favour of more real estate.
Hindsight Bias is a common bias in which a person believes something is true after the fact, even though it could not have been reasonably predicted. It is not an accurate perception of reality. An example of this is how “many people now claim that signs of the technology bubble of the late 1990s and early 2000s (or any bubble from history, such as the Tulip bubble from the 1630s or the South Sea bubble of 1711) were very obvious. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time, it probably wouldn’t have escalated and eventually burst.” What this means for real estate and the stock market is that people do not recognize that the Canadian housing market is in fact in a bubble, nor will they until it peaks and crashes. Conversely, they will not recognize that stocks are historically cheap until they have risen significantly from their lows.
Recency Bias on the other hand “is the tendency of investors to extrapolate recent events into the future indefinitely.” Since real estate has outperformed stocks over the past decade, investors are extrapolating that real estate prices will continue to outperform stocks. Therefore, they continue to purchase ever more expensive real estate and avoid investing in historically inexpensive stocks, exactly the opposite of what they should be doing.
Confirmation Bias is the process of accepting information that confirms a preconceived opinion and ignoring or rejecting information that opposes that preconceived opinion. For example, if an investor believes that real estate is a better investment than stocks, the recent trend of real estate outperforming the stock market confirms her preconceived idea. When confronted with strong evidence that the real estate market is in a bubble, she will reject the evidence and look for additional evidence to support the preconceived bias that real estate is a great investment. This also confirms the preconception that stocks are a bad investment when compared to real estate because stocks have underperformed real estate over the past decade. The confirmation bias will cause investors to look for evidence confirming their preconceived opinions, while ignoring or rationalizing the evidence that these preconceived opinions may be wrong. This type of bias can lead to faulty decision making, because one-sided information tends to skew an investor’s frame of reference, leaving them with an incomplete picture of the situation.
A final bias is known as Herd Behavior, “which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice.” This was evidenced during the tech bubble in 2000 which eventually collapsed and is being repeated with the current Canadian housing bubble. If everyone else is investing in real estate, it must be a good investment. The majority cannot be wrong (so the belief goes) even if there is strong evidence that a particular action or idea is irrational or incorrect. The tendency is to follow the masses because they might know something that the individual does not. “This is especially prevalent in situations in which an individual has very little experience.”
In the face of strong evidence that real estate is in a bubble and stocks are historically cheap, it is not given that investors will choose to sell what is obviously expensive to purchase what is clearly cheap. For that to occur investors must overcome their biases, research and verify the evidence, and make rational decisions based on that evidence.