Self-delusion, overconfidence, over-reliance on rules of thumb and human emotion can overcome the best investment minds, says Weijia Wang
The recent economic crisis is sometimes described as a ‘Black Swan' - a previously inconceivable circumstance which was observed in shocked disbelief even by those experienced in market behaviour.
It seems that real economic processes only explain part of the observed crisis. Behavioural finance investigates how human psychology influences the world and the actions of financial markets, where human needs, desires, goals and motivations lead players in the market to make errors because of self-delusion, overconfidence, over-reliance on rules of thumb and human emotion. Unlike neo-classical economists, who attribute the market anomalies to poorly specified models or imperfect information, behaviourists argue that such anomalies are readily understandable in the context of human behavioural traits.
By understanding these traits and the reasons for them, financiers are increasingly looking to utilise these insights to avoid making further mistakes - and even to exploit the misjudgements of others.
While this emerging field of enquiry has for some time been integrated into the analysis and operation of the equity and bond markets, it is less recognised and understood by practitioners in the property industry. What can we in property learn from the work of behaviourists in other investment markets?
The global pioneer of behavioural finance, Hersh Shefrin, organises the behavioural traits of investment practitioners into two main types: errors relating to use of rules of thumb or ‘heuristics', and errors relating to the way in which problems are framed. These are described below and it is interesting to muse on the extent to which they might be observed in the property market.
Investors develop rules of thumbs experientially over time to help them cope with the sheer amount of information they have to process. These are often articulated as ‘educated guesses', ‘intuition' or ‘common sense'. They help practitioners to be efficient but they can also lead to error.
One main heuristic-driven bias describes the practice of making estimates by basing or ‘anchoring' on an initial value and adjusting to yield a final answer, and the tendency to update a belief too slowly or modestly once it has become established. For example, negotiations on a purchase price will be ‘haggling' around the initial quoted price, rather than a detached assessment of true value.
Second is overconfidence, where investors tend to overestimate their knowledge, underestimate risks and set overly narrow confidence bounds around what might happen - resulting in them being surprised more often than they expect.
Third is a preference for the familiar, where investors overvalue (underestimate the risk of) what is familiar to them and undervalue (overestimate the risk of) what is not.
We have probably all observed such behaviours in the commercial property market. Indeed, much of the thinking about the recent property market cycle was couched in terms of ‘comparing and contrasting it' with previous market episodes in the 1970s and 1990s. However, it seems that the trauma many property investors felt with respect to both the speed and amplitude of the recent market cycle suggests that we draw our confidence bounds too narrowly when we forecast market outcomes.
Similarly, how is it that, over the long term, the City of London office market has proved a relatively poor performer on a risk-adjusted basis when it is the market with the most data on it and where most UK property investors work on a daily basis? Isn't this the market they should get least wrong? Is it because investors are overconfident about their market knowledge and consequently serially overpay for assets they ‘know so well'?
When it comes to errors resulting from Frame Dependence, behaviouralists suggest that what humans decide to do in any given circumstance relates closely to the context in which any given decision is framed, rather than simply the nature of the financial payoff.
One example is Loss Aversion, where investors irrationally hang on to assets rather than sell them at a loss in the desire to ‘break even'.
Second is the tendency to Minimise Future Regret. This relates to the sometimes irrational strategies that investors who have experienced a loss later adopt in the belief they will help them avoid further loss and renewed ‘regret'.
Another framing behaviour is where investors think in nominal rather than real terms and are betrayed by their focus on the face value of money, rather than its real purchasing power. The effect of inflation is an example of this trait, known as Money Illusion.
Prospect Theory argues that investors are driven by the ‘fear of loss', generally preferring to take a guaranteed gain from an asset rather than the chance to make a larger but uncertain gain, and preferring to hold assets and risk making a potentially greater loss, rather than accepting a lesser but certain loss. Such behaviour often leads investors to transact assets earlier or later than is optimal.
Behaviouralists argue that most investment practitioners are typically having to make multiple decisions concurrently. This complexity makes the ‘frame' within which decisions are made opaque. This materially affects decision-making, laying investors open to inherent biases and the making of mistakes.
When, within a recent 12-month period, the IPD Monthly Index registered both its worst and best-ever quarterly performances in a time when rental growth prospects remained stable (and poor), it does suggest we need more than just rational investor theory to fully understand how our market operates and to make accurate forecasts.