Family homes shouldn’t be viewed as an investment or a commodity
When people view homes as an investment rather than a family home, prices become volatile, and it disrupts people’s financial lives.
Homeowners love it when houses go up in price; after all, it makes them rich. During a home price rally, the bulls intoxicate with greed and obsess about owning real estate as an investment. However, once houses become an investment, the prices of houses begin to behave like an investment, and volatility enters the system. Houses should not trade with the volatility of a commodities market because it causes more harm than good.
Price volatility is a very disruptive feature in a housing market: the upswings are euphoric, and the downswings are devastating — and there are downswings. Declining house prices are emotionally and financially draining both to individuals and to the economy as a whole. The upswings create massive amounts of unsustainable borrowing and spending, and the downswings create an economic contraction, millions of foreclosures, and a plethora of personal bankruptcies. Is the ecstasy of the rally worth the despair of a crash?
There are technical reasons for a market crash (foreclosures, credit tightening, etc.), but market psychology plays a large roll in the process. The technical factors cause shifts in psychology among the market participants which exacerbate market moves.
The Psychological Stages of Market Bubbles
Markets are the collective actions of individuals, and the psychology of the markets can be broken down to the psychology of the individual participants who make it up.
When prices first drop, the market enters the denial stage. Individual market participants feel confusion and avoid the truth, motivated by fear they were wrong to purchase when they did, causing them to lose money. Owners in denial seek ways to quell their fears through drinking even more kool aid. Bulls in the denial stage will frequent housing blogs to convince the bears they are wrong. Unfortunately, they only succeed in convincing themselves, and in doing so, they fail to act when they could have minimized the financial pain.
When the markets enter the fear stage, the little voice inside of each buyer gets louder and louder, boiling over into anger, frustration, anxiety, etc. The individual desperately seeks ways to maintain denial, but reality becomes stronger than denial. If they imagine the reality they deny is the truth, the become despondent because reality is too painful to accept, which pushes them back into denial.
Finally, “as the going gets tough, the tough get going,” and the individual seeks ways to get out of the problem through emotional bargaining. Some will take action. Perhaps they lowering an asking price, take the property off the market and complete some renovations to “add value.” Some will not take action, and they lapse back into denial because the market is “coming back soon.”
Note that these psychological stages all occur in the fear stage of the market. Those owners who chose to lower their price as part of their bargaining may get out with minimal losses (assuming they lower it enough to actually sell.) Those that chose other courses of action, lose much more money.
Each individual only reaches acceptance when they sell their house. This is when we enter the stage of market capitulation. Collectively, everyone in the market accepts prices are going to drop further, and they need to get out: Now! Of course when everyone knows prices are going to drop, and everyone is trying to sell, there are no buyers. This puts prices into free-fall until buyers are ready to buy again.
This is more than just a quaint theory.I watched in glee and amazement as lenders sold houses for crazy-low prices in Las Vegas in 2011. Understanding this process has real-life implications.
Since buyers in the aftermath of a bubble tend to be the risk adverse who did not participate in it, they will make cautiously low offers on properties. This cautious buying together with desperate sellers causes the market to drop below normal valuation standards. The market enters the despair stage. Here the market participants think nobody wants the asset, and nobody ever will again. Of course, nothing could be farther from the truth as those who recognize the fundamental value of the asset are buying it in preparation for the next cycle.
In a commodities or securities market, you simply cannot have a rally, unsupported by valuation measures, without a crash back to fundamental value. The rally in house prices from 2003-2007 was not caused by a rally in the fundamental valuation measures of rent or income. The primary mechanism was the proliferation of exotic mortgage products effectively banned by Dodd-Frank.
Many people forgot the primary purpose of a house is to provide shelter — something which can be obtained without ownership by renting. During the mania, ownership ceased to be about providing shelter and instead became an access point to one of the world’s largest and most highly leveraged commodity markets: residential real estate.
Trading is a very difficult endeavor. The vast majority of active traders lose money, and most don’t last very long. Traders who “chase the market” generally lose money. Unfortunately, the mania from 2003 to 2007 prompted many to chase the market and buy at the top of a massive housing bubble.
The Psychology of the Bubble
The above graph is an excellent depiction of the psychological stages of a market bubble. It is fairly easy to put timeframes to each of these stages as displayed by our local housing market:
- Take off: 1998-1999
- First Sell Off: 2000
- Media Attention: 2001-2002
- Enthusiasm: 2003
- Greed: 2004-2005
- Delusion: 2006
- Denial: 2007
- Fear: 2008
- Bear Rally: 2009
- Capitulation: 2010
- Despair: 2011
- Bottom: 2012
- Return to the Mean: 2013
I first predicted this in 2007 in the post Predictions for the Irvine Housing Market:
- Median sales price will decline approximately 40% from near $700,000 to near $400,000 over the next 5 years.
- There will be a multi-year flattening of prices at the bottom.
- Sustained appreciation will not return until 2013 or later.
- Peak bubble prices will not be seen until 2027 (unless we get another bubble).
So how did I do? (See: Predictions versus reality: Irvine Renter’s track record)
Prices did not fall as far as I said they would. But how wrong was I?
If prices only fell 2/3 of the amount I projected, was I 1/3 wrong? If prices are 50% below expectations, how wrong am I? Was I at least 66% right?