What if investors’ brains are wired to make the wrong decisions in real estate? A new research paper released by Fidelity International indicates we could be the victims of our own neural connections – at least when it comes to certain built-in biases about how risk, rewards, and geography affect our real estate portfolios.
According to new research from Fidelity International, real estate investors may not be as rational as we might like to think. Their study called, “Addressing built-in biases in real estate investment,” applies behavioural psychology to the minds of commercial real estate investors (1).
Neil Cable, Fidelity’s head of European real estate investment said, “With the next wave of internationalization of property investment underway, now is a good time to ask the question – are established industry investment practices fit for purpose? The answer appears to be a resounding ‘no.’”
The report says it’s for “investment professionals only. Not for use by private investors.” But since behavioral psychology concepts apply to all humans, all can learn a thing or two from this study.
Behavioral psychology studies how our brain’s ingrained biases affect how we approach problems. This includes the puzzle of where and how to invest, and sometimes can cause us to make irrational decisions. When behavioral psychology is applied directly to investing, it actually has its own name, behavioral finance. This has been a topic of study at colleges and universities for years, but usually is applied to stock market investments, not real estate… until now.
The report lays out five biases that the researchers said affect real estate investing decisions and make us less likely to make rational decisions about our investments.
The Framing Bias
This basically means that our brains frame the market in such a way that we subconsciously believe average market returns are impossible to achieve.
The Anchoring Bias
Anchoring involves fixating on a specific measure of success at the expense of other factors. Fidelity reports, “The most harmful kind of anchoring within real estate occurs when investors fixate on capital gains, yet this is still how most investors tend to decide where to invest.”
The Loss-Aversion Bias
No one likes to lose money, and real estate investors tend to lose their patience after three consecutive losses. “The irony is that markets often correct in three downward waves, meaning that investors tend to sell at the very bottom of the market,” observed Cable.
The Home Bias
Real estate investors, probably more than any other asset class of investors, like investing in their domestic markets. Even if you are willing to go outside your geographic region (as more and more investors are), it is relatively rare to find a U.S. investor with broad holdings outside the country. Fidelity says, “Overinvesting in domestic assets exposes portfolios to concentration risk.” Now keep in mind that the report was commissioned by Fidelity International, so perhaps they are showing a little bias themselves!
The Herding Bias
Real estate investors tend to like rules and look for them wherever we can find them. When we do find them, we try to repeat them, and often we look to other successful investors to establish rules for our own investing. Fidelity researchers say that our brains are designed to take this good idea too far and apply the rules without the necessary context. Essentially, keep playing by our internal “rules” when the market has started to change and we should be using a new set of them. Cable warned this is “a dangerous game to play in real estate.”
Mike Phillips, an analyst for Bisnow.com London, commented on the results of the Fidelity report, “If real estate investors were rational, then the booms and busts that the cycle experiences would be much less pronounced – as prices get higher, demand should drop off. Instead real estate is particularly prone to positive feedback loops.” He added that investors also tend to hold on to assets “for longer then they should as prices fall, then finally capitulate when prices are at their lowest.”
By this measure, we basically create our own extreme market cycles and then fall victim to them, all while trying to be most logical and rational that we can be about our money.
The Fidelity report offers a number of ways to limit the amount of influence your brain has on your investments, but they pretty much boil down to looking at each investment in isolation without factoring in historical trends, focusing nearly exclusively on cash flow, and trying not to make “rules” for yourself about your investments that may become obsolete depending on the market cycle.
What I’ve seen over the years is the frantic search for property when prices are at their peak. Investors tend to believe that conditions will stay as they are. If prices have gone up for some years, many people think the trend will continue. If prices fall, many people stay away for fear of more losses.
This couldn’t be further from the truth. All you have to do is look at history and charts to see the moment the masses jump into an asset class – usually at the top when all the early investors have already made their money – it’s too late, and usually right before the tides turn.
When it comes to residential real estate, affordability, or lack there of, is the #1 factor contributing to the changing tides.
So pay attention to fundamentals, and your biases.