Institutional investors pride themselves on their ability to remain utterly rational, balancing every decision based on the powers of reason, and rigorous interrogation of data. This is as true for property professionals as it is for equity and fixed income investors.
Assuming, though, that investors are wholly rational decision-makers gives only a partial view of the world. There is a need for a better understanding of how the humans behave when managing economic processes, and when and why psychology clouds investor decision-making.
Fortunately, there is a growing field of research examining the systematic biases relating to investment practices. Behavioural finance looks at how human psychology influences the world and the action of financial markets, where human needs, desires, goals and motivations lead players in the market to make mistakes of overconfidence, over-reliance on rules of thumb and human emotion. Financiers are increasingly use these insights to avoid further mistakes. They are also keen to exploit the misjudgements of others: a number of behavioural finance-based investment vehicles have emerged, which target mispriced assets.
In real estate, an asset class which Asian institutions increasingly consider as an important component in a multi-asset fund for asset allocation reasons, research into the issue is conspicuously absent. Nonetheless, some of the research in other asset classes may give insights into commercial property.
The pioneer of behavioural finance, Hersh Shefrin, organised the behavioural traits of investment practitioners into two types; first rules of thumb, and second errors relating to the way in which problems are framed.
Shefrin found that investors develop rules of thumbs experientially over time to help them cope with the sheer amount of information they have to process. These are often called educated guesses, intuition or ‘common sense’. They help practitioners to be efficient, but also to make mistakes.
A quintessential rule-of-thumb error is the practice of making estimates by basing or “anchoring” on an initial value and adjusting to yield a final answer, and the tendency to update a belief too slowly or modestly once it has become established.
Retailers know this, which is why $5.99 is a more common price tag than $6.02. It is also evident in property investment, where negotiaters haggle around the initial quoted price.
The buyer may negotiate the price down significantly but it may still be more expensive than its true value. The ‘heavy discount’ that is secured could be the trick to make the investor feel better for paying more than they should do.
Anchoring can also be a source of frustration as investors tend to have short memories, and are therefore susceptible to recency bias when they make investment decisions. The over-emphasis and privileges given to the information recently collected can feed into a psychological “greed and fear” impact, thus lead to greater market volatility than that suggested by the true fundamentals.
In emerging real estate markets including China, valuations with little reference, and market practices less transparent or complex to interpret will push investors towards subjective decisions. All behaviour tricks such as pricing discount or money illusion will have even bigger role in these markets.
The forgetful and emotional investors illustrated above may partially explain why the relatively mature markets such as Singapore and Hong Kong repeatedly experience short and volatile property cycles, while overconfidence and herd behaviour are also suspected to play an important role in forming such market mechanism.
Overconfidence illustrates the bias that investors tend to overestimate their knowledge, underestimate risks or set an overly narrow confidence bounds around what might happen - resulting in them being surprised more often than they expect to be. Indeed, much of the thinking about these Asia markets with vigorous economic growth has been around the prospective increase from the demand side, however, underestimating the risk imposed by the other side of the equation, supply of space.
Amplified by the herding behaviour where people follow each other rather than doing their homework and give a rational judgement of value, such overconfidence attract great amount of “hot money” into the market either leading towards to excess supply of space through development, or big surge or swing in price. This may also be a big driver of asset pricing bubbles often seen in residential markets, where recently governments have to implement various policies to curb market speculations in Singapore, Hong Kong and even China.
The second class of errors result from Frame Dependence: behaviouralists suggest that what humans decide to do in any given circumstance relates closely to the context in which any given decision is framed, rather than simply the nature of the financial payoff.
One example is Loss Aversion: where investors irrationally hang on to assets rather than sell them at a loss in the desire to “break even.”
Another framing behaviour is where investors are swayed by the nominal value of an asset, rather than its real value. They are betrayed by their focus on the face value of money rather than its real purchasing power. The affect of inflation is an example of this trait, known as Money Illusion.
Prospect Theory suggests that investors may prefer to take a guaranteed, but relatively small gain from an asset rather than the chance to make a larger but uncertain gain. The other side of this coin is that they will tend to take greater risks when confronted with the prospect of a loss.
Such behaviour often leads investors to transact assets earlier or later than is optimal.
So, if we know such things, why don’t we alter our behaviour? Well, unlike the straightforward, orderly and transparent decision-making environments most conventional finance text books assume, it is argued that most investment practitioners are typically having to make multiple decisions simultaneously. This complexity makes the ‘frame’ within which decisions are made opaque. This materially affects decision-making, laying investors open to inherent biases and the making of mistakes.
It is apparent that there is work to be done for real estate fund managers to understand behavioural finance better and that work to date barely scrapes the surface of this burgeoning field.
However, the behaviours identified certainly feel familiar and the experience of global real estate markets in recent times offers powerful evidence of their existence within today’s property market.
Dramatic market movements suggest we need more than just rational investor theory to understand how our market operates and to anticipate it in the future, as property investment becomes an increasingly data-rich asset class. •
Scott Girard is chief executive and investment officer of Prudential Property Investment Management Singapore. Weijia Wang is a PRUPIM research analyst.