Without always knowing it, property investors are pre-programmed with a range of biases which may cause them to interpret information incorrectly and thus undertake sub-optimal investment decisions.
Let’s discuss 9 of the key biases that Australian property investors must overcome…
1. Hindsight bias
How many know-it-all commentators now confidently proclaim that the financial crisis and resultant property downturn were both inevitable and easily predictable?
There is only one problem with this: it is twaddle.
In truth, only after the event can these matters be viewed with any such clarity. Don’t believe me?
Go back and read what the experts were saying in 2007.
And I quote: “The subprime crisis is a storm in a teacup”.
2. Confirmation bias
Confirmation bias is the tendency to begin with an answer and then search for evidence to support the preconceived outcome.
How many times have I bought a stock and then searched for the fundamentals to support the decision thereafter? Too many!
As an investor in the suburbs of capital cities I need to be wary of believing that an inner- or middle-ring suburb of a capital city must always surely outperform a regional property market, for this is clearly an unsubstantiated bias.
Conversely, regional investors are sometimes guilty of finding a property with a high rental yield then citing meaningless statistics and anything from new bus routes to bowling alleys or bingo halls as reasons why their chosen suburb must surely be the next boomtown.
In reality, growing demand from population growth and a limited or capped supply are likely to be superior indicators of long-term capital appreciation.
Instead, investors should take heed of Charles Darwin: be sceptical of your preconceptions and try to isolate the reasons why your investments might be wrong.
Attempt to disprove your own theories rather than continually defending them.
3. Anchoring bias (or focalism)
Anchoring is the risk that one piece of esoteric information clouds an entire investment decision or process.
The most common failing in the stock markets is for investors to anchor fair value around the price they paid for a stock, whereas an intrinsic value is not correlated to the price that an individual investor has paid for a parcel of shares.
Where does anchoring occur most frequently in property? In negotiations.
Studies show that initial offers in negotiation processes have a far stronger influence on the outcome than subsequent offers and counter-offers. Ergo, choose your first offer very carefully.
4. The Halo effect
If we initially see a person or an investor in a good light, it is difficult subsequently to see them as otherwise, even when the facts begin to show our preconception to be inaccurate.
The same can be true of asset classes, including residential real estate.
Australian property is unusual in that perhaps the majority of mainstream commentators has not yet invested through a recession, and thus may be prone to viewing property in an overtly positive light.
This was evidenced by much misplaced excitement in the Twittersphere where property commentators cheered the interest rate cut to 3.00%, seemingly pre-empting an inevitable price boom.
In reality, interest rates were cut to historic lows because of the worrying weakness of the non-mining sector of the economy.
Indeed, the lack of ex-mining GDP growth in the Q3 print is likely to result in yet further rate cuts in 2013.
Interest rates flirting with the zero-bound in no way guarantee property price growth as recently witnessed in more countries than I have space to name.
5. Negativity bias
On the flip side, others assume perpetual gloom and doom. Suffice to say that I’ve heard about property valuations being “vastly over-priced” for every one of at least the past 15 years.
My parents tell similar tales from the 1960s.
The game Monopoly was originally designed to portray the iniquity of landlords controlling over-priced US properties for which they charged extortionate rents.
The idea was conceived in 1904 – when an Aussie 3 bedroom house cost around $500 and rented for approximately $1.50 per week.
The obvious truth is that the long-term trend of stock markets and property prices is an upwards one.
6. Recency bias
When times are good humans have a tendency to believe that they will remain so forever.
The same is true when times are bad.
In 2007 many Western Australian investors refinanced properties to re-invest equity in Perth on the basis that the market had performed so spectacularly for them in the preceding years.
Naturally, just as was the case for wealthy Melbournians at the peak of the market in 2011, after the phenomenal boom better investment opportunities existed elsewhere and in other states.
7. Skill bias
Skill bias is the risk that education causes an investor’s confidence to increase faster than their equivalent skill levels, resulting in brash over-confidence.
Some of the greatest minds in the world are employed as fund managers and at major banks, yet they sometimes still fail.
Even property investors who have only experienced moderate levels of personal success may begin to feel infallible.
This is a dangerous mind-set.
8. The control illusion
The control illusion is reflected in investors tending to blame investment loss upon ill fortune, whereas gains are easily attributed to skill.
This is especially true in property: a booming real estate market can make investors feel extremely smart, but in truth much of what occurred was clearly beyond the control of an individual investor.
9. Risk perception bias
Risk perception bias is where individuals in trying to avoid one risk instead fall prey to another – and perhaps one which is potentially more harmful.
The most frequently quoted example is that after 9/11 people became disinclined to fly under the false illusion that long-distance transportation by automobile had suddenly become safer than aviation.
After the financial crisis, in a bid to escape “risky and volatile” stocks (which were trading at historically cheap prices) investors lurched into the perceived safety of “lower risk” assets such as bonds or gold when they, of course, were trading at record high valuations.
Just as with most asset classes, the best way to invest in property is to acquire assets counter-cyclically when sentiment and prices are low and everyone seems to be telling you that it can’t be done.
Such is the madness of crowds.