Most homebuyers make irrational purchase decisions
Housing markets are dominated by millions of individuals making emotional decisions rather than a small number of highly-trained professionals.
People buy houses as family homes for emotional reasons, and not always rational ones. Many analytical people conduct research, analyze financial returns, and so on, but this is generally only a rationalization for what is a deeply personal and emotional decision.
A place to raise a family
Many people buy because they want to provide a safe and comfortable home to raise a family. It’s a primal urge. Although it shouldn’t make a difference, there is an emotional quality to home ownership that is not replicated by renting. Satisfying one’s emotional needs is an instinctive drive, and this compels many people to buy houses. Unfortunately, some people turn this emotional satisfaction from home ownership into a reason to feel superior to their renting brethren, a group they perceive as being less involved with family, neighborhood and community.
Be a part of a neighborhood and community
As people grow and develop during their life cycle, they first learn to take care of themselves, then their families, then their neighborhood and community, and finally the whole world. Being part of a broader community one can work to build and improve is a basic human need. Most people see this as a natural extension of buying a house. They dream of watching the children play with the others in the neighborhood, enjoying block parties, and participating in organized events. All things being equal with the house, people will chose to locate in neighborhoods with others of their same demographic with whom they can make friends and socialize.
Following parent’s advice
Many people buy homes simply because their parents did. People grow up, get married, buy a house, have children, and become part of a community because that’s what their parents did, and often this behavior is strongly encouraged by the parents who will even help with down payment money to get started. There’s nothing wrong with this. Parents generally have good advice due to their broader life experience.
Rational, financial reasons to own
There are sound financial reasons for buying houses: build equity, inflation hedge, acquire asset, and obtain a tax deduction, but the primary reasons are emotional, not financial, and therefore, the behavior of homebuyers isn’t always rational.
Home prices have been climbing. They have risen 27 percent nationally since 2012, even more in places like San Francisco. But why worry? If you accept the efficient markets theory — and believe that real estate is an efficient market — then these prices are based on “new information,” even if you don’t know what that information is.
I find it amazing that 10 years after the peak of the housing bubble that anyone places any faith in efficient markets theory. In 2006, the efficient markets theory would claim the prices were rational and appropriate, but prices fell 30% shortly thereafter.
Bubble era prices were rational if you believed the fallacies of the housing bubble, but once these beliefs were exposed as folly, the market corrected quickly. Is a market rational when it’s gripped by a mania? When the root premises on which the market rests are a foolish delusion, then the market is acting rationally based on bad information. Is that rational? It certainly doesn’t look rational from the outside.
The problem with this kind of thinking is that the efficient markets theory is at best a half-truth, as a voluminous literature on market anomalies shows. What’s more, even that half-truth is grounded mainly in the stock market, which attracts professional investors who sometimes do make the market behave efficiently.
The housing market is another matter. It is far less rational than even the often irrational stock market, for a couple of important reasons.
The main reason housing markets are irrational is because it’s primarily a market of non-professional individuals making emotional decisions. Housing is not a market dominated by a small group of well-trained professional investors operating on careful analysis and reasoning.
First, most investors find it difficult to understand how housing supply responds to changes in demand. Only a small minority of people think carefully about such things. Second, it is very hard for the minority of smart-money investors who do understand such matters to bet against bubble-level prices in real estate markets. In housing, the smart money has relatively little voice.
I was one of many people who foresaw the housing bust, but I was unable to profit from the decline. The only people who made fortunes from the housing bust were traders who shorted financial stocks and hedge fund managers like John Paulson who shorted the complex derivatives made from mortgages. Many more people made money by purchasing rental homes after the crash, but there aren’t many financial products designed to profit from the crash itself.
In 1977 Edward M. Miller pointed out in The Journal of Finance something that should have been obvious: Efficient markets require the possibility of selling short. In the stock market, for example, with short-selling, people who think the market is overpriced and headed for a fall can borrow shares and sell the borrowed shares at the current high price. If share prices do indeed fall, they can buy the shares back at a lower price and repay the loan, with a profit.Short-selling helps prevent bubbles from forming, but such negative bets cannot easily occur in the housing market. You can’t routinely borrow a house and sell it, promising to buy back the same house later to repay the loan.
Markets without the possibility of making these negative bets will be inefficient. That’s because if it is not possible to short, the smart money can do no more than avoid holding an overpriced asset. Canny traders are forced to sit on the sidelines, and watch in futility as prices decline as they expected. Without short-sellers, there is nothing to stop a group of ignorant investors — who get some ill-conceived idea that a certain investment is just terrific — from bidding up prices to extravagant levels. In the housing market, that poses an enormous problem. …
The banks would argue this is a feature, not a bug. Lenders want to protect the value of their collateral, so the last thing they want to see is a mechanism that would prevent house prices from rising and might even cause house prices to fall.
The bottom line is that there is no reason to assume that the real estate market is even close to efficient. You may want to buy a house if you love it and can afford it. But remember that you cannot safely rely on “comparable sales” to judge that the price is fair. The market isn’t efficient enough for that.
Efficient Markets Theory
The efficient markets theory is the idea that speculative asset prices always incorporate the best information about fundamental values and that prices change only because new information enters the market and investors act in an appropriate, rational manner with regards to this information. This idea dominated academic fields in the early 1970s. Efficient markets theory is an elegant attempt to tether asset prices to fundamentals through the common-sense notion that people would not behave in irrational ways with their money in financial markets. This theory is encapsulated by the “value investment” paradigm prevalent in much of the investment community.
In an efficient market, prices are tethered to perceived fundamental valuations. If prices fall below the market’s perception of fundamental value, then buyers will 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 will 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 does not 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.
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.
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. 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.
The efficient markets theory does explain 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.
It’s difficult, if not impossible, to explain the housing bubble through efficient markets theory.