Housing is one of the least efficient markets
Due to a high rate of amateur participation and a lack of accurate information, housing markets are among the least efficient in the financial world.
The efficient markets theory postulates that speculative asset prices always incorporate the best information about fundamental values. Adherents to this theory believe that prices change only because new information enters the market and investors act in an appropriate, rational manner with regards to this information. It’s a gratifying theory that portrays investors as wise and rational. Unfortunately, it has no basis in reality.
Efficient markets theory dominated academic fields in the early 1970s. Academics attempted to tether asset prices to fundamentals through the common-sense notion that people would invest their money rationally. This theory encapsulates the “value investment” paradigm prevalent in much of the investment community.
Efficient Markets Theory
In an efficient market, prices tether to perceived fundamental valuations. If prices fall below the market’s perception of fundamental value, then buyers enter the market and purchase the asset until prices reach their perceived value. If prices rise above the market’s perception of fundamental value, then sellers enter the market to sell the asset at inflated prices.
Efficient markets theory explains the majority of market behavior, but it has one major flaw which renders it inoperable as a forecasting tool: it fails to explain those instances when prices become very volatile and detach from their fundamental valuations. This becomes painfully obvious when adherents to the theory postulate new metrics to justify fundamental valuations that later prove to be completely erroneous.
The failed attempts to explain anomalies with the efficient markets theory lead to a new paradigm: behavioral finance theory.
DEC 8, 2016, By Noah Smith
Back in 2005, Kevin Lansing of the Federal Reserve Bank of San Francisco showed that it doesn’t take very much human error to generate extrapolative expectations. If people start believing, even for a short time, that recent trends are the new normal, they will start paying higher prices, which locks the trend in place and lends credence to their belief. Eventually things spiral out of control before they come to their senses. Other economists have shown that even if just a fraction of investors think this way, it can cause repeated bubbles.
Extrapolative expectations is the fallacy where people believe short-term price movements will continue on forever. It’s very common, it crosses all markets, and it’s generally easy to spot — though much more difficult to time.
For example, over the last month since Donald Trump’s election, stock prices rallied sharply. As the market rally dragged on, speculators began buying simply because everyone else was buying and prices were going up. People who bought over the last week or two really believe prices will never fall below their entry point and prices will continue to rise rapidly forever.
Realistically, this stock market rally will come to a nasty end, and the investors who bought in the late stages will sell for a painful loss, but knowing this doesn’t help much because the timing of the retracement is very elusive. The selloff might start tomorrow, or the rally may go on for another month or two. Since it’s emotional herd behavior, no reliable indicators exist to predict the best time to sell short.
A recent paper by Edward Glaeser and Charles Nathanson applies the idea to housing markets. In their model, people decide how much a house is worth by making a guess about how much people will want to live in the area in the future. If buyers expect local demand to increase, it makes sense to pay more for your house, since the influx of other buyers will then drive up prices.
But how do you know whether demand will increase? One obvious way is to look at recent trends. If prices have been going up, it’s a signal that the area is hot. Glaeser and Nathanson note that in surveys, about 30 percent of homebuyers say outright that they use recent price trends to determine how much a home is worth; since others probably do this unconsciously, the true percentage is even larger.
Recent trends are the worst possible indicator to rely on. When I bought rental properties in Las Vegas, the trend was still down, but since the downtrend was old and weakening, I ignored the recent trends and bought bargain properties.
Glaeser and Nathanson’s model makes one crucial assumption — that investors rely on past prices to make guesses about demand, but fail to realize that other buyers are doing the exact same thing. When everyone is making guesses about price trends based on other people’s guesses about price trends, the whole thing can become a house of cards. The economists show how if homebuyers think this way, the result — predictably — is repeated housing bubbles and crashes. …
But to gain wide acceptance, extrapolative expectations will have to overcome years of entrenched convention in the economics profession. The near-ban on using anything other than rational expectations is still very strong. In the hunt for truth, sociology is often the greatest barrier.
Behavioral Finance Theory
Behavioral Finance abandoned the quest of the efficient markets theory to find a rational, mathematical model to explain fluctuations in asset prices. Instead, behavioral finance looked to psychology to explain asset valuation and why prices rise and fall.
The primary representation of market behavior postulated by behavioral finance is the price-to-price feedback model: prices go up because prices have been going up, and prices go down because prices have been going down. This simple explanation is far more predictive of what happens in the real world.
If investors are making money because asset prices increase, other investors take note of the profits being made, and they want to capture those profits as well. They buy the asset, and prices continue to rise. The higher prices rise and the longer it goes on, the more attention is brought to the positive price changes and the more investors want to get involved, the essence of a financial mania.
These investors are not buying because they think the asset is fairly valued, they are buying because the value is going up. They assume other rational investors must be bidding prices higher, and in their minds, they “borrow” the collective expertise of the market. In reality, they are just following the herd.
This herd-following has long been a valid investment technique employed by traders known as “momentum” investing. It is not investing by any conventional definition because it relies completely on capturing speculative price changes. Success or failure often hinges on knowing when to sell. It is not a “buy and hold” strategy.
Behavioral Finance Theory
The efficient markets theory explains the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon.
There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations. In the Great Housing Bubble, the primary precipitating factor was the lowering of interest rates. The precipitating factor simply acts as a catalyst to get prices moving.
Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the “smart money” must know something, and there is a widespread belief prices could not rise so much without a good reason: Herd mentality takes over.
Psychological Stages of Bubble Market
Housing is one of the least efficient markets because most of the participants aren’t seasoned professionals. Most homebuyers believe extrapolating recent trends is a valid and reliable method of screening potential investment opportunities. In other words, most participants in the housing market don’t realize their behavior is part of a larger problem.
Housing markets are also inefficient because not all market participants have access to the same information. Sellers always know more than buyers, and realtors generally focus more on manipulating people into deals rather than educating them to level the playing field.
Taken together, the general lack of understanding of how markets work coupled with a data asymetry caused by generally poor agent representation, and housing markets become one of the least efficient markets functioning today.