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Key takeaways
Have you ever wondered what leads to the ups and downs of our property cycle?
Well…the markets are not just driven by numbers and data, but largely by human psychology.
Psychologists have shown that the mind of an individual investor is a fascinating labyrinth of emotions and cognitive biases.
And these cognitive biases impact our investment decisions and often become more pronounced during periods of market volatility as we’ve experienced over the last few years.
Residential real estate is an “Imperfect Market” which creates great opportunities for those who understand what really drives our housing markets.
In this article, I show you how to take advantage of this.
Have you ever wondered what leads to the ups and downs of our property cycle?
Well…when we delve into the realm of investment markets, we’re navigating a sea guided not just by numbers and data but largely by human psychology.
And yes, those ever-oscillating curves of booms and downturns that shape our financial landscape are deeply rooted in the human mind.
Let me explain…
The Mirage of Efficient Markets
When I first started investing I knew nothing about economic fundamentals or the drivers of our property markets or how our housing markets were driven by the fear and greed of buyers and sellers.
Then somewhere along the line, I learned about the Efficient Markets Hypothesis, a darling theory of the past, which argued that financial markets were rational entities that perfectly reflected all available information.
However, it didn’t take me long to realise the property markets are far from perfect markets.
As opposed to shares where all shares in the same company are sold at the same price and, in general, all the players in the market have similar knowledge; the property market is “imperfect.”
It is in fact driven by fear and greed and a whole lot of people making irrational decisions based on what they think a whole lot of other people are going to be doing.
Now that’s not a bad thing…it meant I could use my knowledge and contacts as well as my negotiation expertise to my advantage, but more of this in a moment.
Just look at these property cycles
The following chart from commentator Michael Matusik shows the up-and-down phases of Australia’s housing market over the last 40 years.
While these property cycles were driven by a myriad of factors including interest rates, economic factors, government incentives and consumer sentiment; several aspects of human psychology interacted in helping drive the phases of these cycles, including individual lapses of logic and crowd psychology.
You see individuals are not rational when it comes to money and investing.
Well…maybe apart from you and me!
The Individual Investor: A Case of Irrationality
Psychologists have shown that the mind of an individual investor is a fascinating labyrinth of emotions and cognitive biases.
And these cognitive biases impact our investment decisions and often become more pronounced during periods of market volatility as we’ve experienced over the last few years.
Let’s take a closer look at some of these:
- Confirmation Bias: Investors seek information that confirms their existing beliefs. During a boom market, this bias can lead to overlooking warning signs, whereas in a downturn, it can lead to ignoring potential opportunities.
In other words, we tend to be most positive near the peak of the property cycle when we should be most cautious, and then we are most cautious near the bottom of the cycle when most of the downside risk has gone.
- Recency Bias: This bias places undue importance on recent events. After a market downturn like we experienced last year, people may be too fearful to invest, while following a boom, they may become overly confident.
- Herd Behaviour: As humans, we’re inclined to follow the crowd, especially when faced with uncertainty. This can lead to property booms when everyone is buying and downturns when people stay out of the markets because others are worried.
- Emotional Investing. Emotions play a crucial role in investment decisions, often overshadowing rational analysis. Of course, they shouldn’t, and that’s why it’s useful to have a property strategist on your side making sure you stick to your plan.
- Greed and Fear: During a boom, greed can drive investors to take on too much risk. Conversely, in a downturn, fear can lead to overly conservative investment choices.
- Overreaction: Markets tend to overreact to news and events. While the housing market isn’t really volatile in the short term, this overreaction can clearly be seen in the severe price fluctuations in the share market. However, investors who are aware of this tendency can sometimes capitalize on these irrational movements.
Market Cycles and Investor Behaviour
Understanding the typical investor emotions at various stages of the market cycle can aid in making informed investment decisions, rather than irrational ones.
There is a range of emotions that investors can experience and this diagram shows how they span what is called the ‘Cycle of Market Emotions’.
The cycle begins with the optimism of good returns.
As markets move up, we become excited and thrilled at the gains we’re making.
Euphoria hits, and we start to think that we’re really good at investing.
At this point, we may even invest more.
As the markets begin to turn downwards, we start to feel anxiety, then denial, and then fear sets in, which may lead us to sell some of our portfolio.
We also start doubting our investment abilities.
As the markets sink further, desperation sets in, followed by panic, and then capitulation.
At this point, we may exit the market completely, which will be at exactly the wrong time.
We then feel despondent and depressed.
Then as the market moves up again, a glimmer of hope appears, and then relief that our portfolio is recovering.
We then feel optimism again, thinking that we could make some great returns.
And the cycle continues.
Obviously, one investor acting emotionally or irrationally isn’t going to move the market, but when individual irrationalities come together, they don’t cancel out but rather magnify into a cacophony of collective behaviour.
The influence of mass media, conformity pressures, and trending beliefs like “property values can only go up” set the stage for investor-driven booms that lead to the next downturn.
Of course, the housing market is less liquid and therefore less volatile than shares or cryptocurrencies where it is much easier to see the crucial role of crowd psychology, but it seems that social media and the 24/7 news cycle have accentuated irrational behaviour and shorted property cycles.
Let’s look at this in a little more detail…
Australia’s housing markets: the dance of fear and greed
The Australian housing market has seen significant growth over the past decades, but not without its fluctuations.
Financial advisor Stuart Wemyss, of Prosolution Private Clients, produced the following chart which illustrates that property markets have moved in two distinct cycles over the past four decades, being either growth or flat cycles.
However, over longer periods of time, property capital growth is relatively stable i.e., most markets have produced around 7.50% per annum growth over the past 40+ years (which is approximately 5% p.a. plus inflation).
As I said, the table above shows the continual rise in property values for well-located capital city residential dwellings has been punctuated by periods of stagnation and decline.
Interestingly the driving forces behind these fluctuations are often rooted in psychological factors.
The Role of Greed
- Investor Speculation: The promise of capital gains has attracted many investors into real estate and during the boom stage of the cycle, greed can take over rational decision-making, leading to taking on a lot of debt, over-leveraging and buying at inflated prices.
- FOMO (Fear of Missing Out): When property prices are on the rise and the news is full of people supposedly building significant property portfolios and making property windfalls, fear of missing out on potential gains drives more people into the market. This fuels further price growth as demand outstrips supply.
- Government Policies and Incentives: Various incentives, such as the lure of tax benefits or grants for first-time homebuyers, can add fuel to the fire. These policies may encourage risk-taking and further push up prices.
The Role of Fear
- Market Corrections: When the market begins to cool down, fear can set in quickly. Investors in particular, but some overleveraged homeowners may panic and sell, while others sit on the sidelines waiting for someone to ring a bell to announce the market has bottomed.
- Economic Factors: Fear is often exacerbated by broader economic conditions such as rising interest rates, inflation, unemployment concerns and global economic uncertainties.
- Media Influence: Sensational headlines and negative media coverage can instil fear in potential buyers, causing them to hold off on purchasing. This collective hesitation can lead to a self-fulfilling prophecy of a market decline.
How to tame your emotions
Being aware of these psychological factors can help investors develop strategies to mitigate their impact:
- Understand the cycle of emotions.
The better prepared we are, the better we’ll be able to control our emotions when the time arrives. That’s why it is important to realise that markets are driven not only by rational fundamentals but also by irrational human behaviour. Then familiarise yourself with the history of the cycles of our property market and realise that in the long term property values keep rising, but in the short term, there are periods where property values fall and that every market also has had long periods where prices have remained stagnant.
- Long-term Perspective
Adopting a long-term investment perspective can reduce the temptation to react impulsively to short-term market movements. Remember real estate is a long-term game and by that I mean you really must consider what will happen over the next few decades
- Diversification
Having a diversified portfolio can cushion against market fluctuations and reduce emotional reactions to market volatility.
- Professional Guidance
Having a Strategic Property Plan and a proficient team Engaging with a financial professional can provide an objective viewpoint and help investors navigate emotional decisions.
Residential real estate: an Imperfect Market
A moment ago I mentioned that a “perfect market” in economic theory is one where all participants have the same amount of information, the products are identical, and there are no barriers to entering or exiting the market.
Clearly, residential real estate does not meet these criteria for several reasons:
- Asymmetrical Information: Not all buyers, sellers, and investors have the same level of information about property values, local market trends, zoning laws, etc. And even if they have access to all this data, most don’t have the perspective to analyse it properly.
- Heterogeneity of Products: Unlike commodities, each residential property is unique, with different locations, designs, quality, and appeal. Clearly, some locations will outperform others and some properties are classed as A grade but many are not. Even orientation – being situated on one side of the street – can make a property worth considerably more than a property on the other side of the street.
- Barriers to Entry and Exit: Regulations, financing requirements, and the substantial capital involved can create barriers for participants in the market. As property values increase it gets harder to be able to buy an investment-grade property.
But you can use this to your advantage
The imperfections in the residential real estate market create opportunities for those with the skills, knowledge, and strategies to exploit them.
While it may take years to accumulate this knowledge, and an expert perspective is something you just can’t buy, you could get experts like the team at Metropole on your side as we possess several distinct advantages in this imperfect market:
- Superior Knowledge: Metropole’s extensive understanding of market dynamics, property valuation, regulations, and the psychology of success allows us to see opportunities and risks that others may overlook.
- Expert Analysis: With insights from the frameworks I’ve fine-tuned over 5 decades and our research, we have a deep understanding of local and national trends. This enables us to predict market movements more accurately and to position your investments accordingly.
- Strategic Networks: Our connections with other experts and industry players provide valuable insights and opportunities that are not available to the average investor.
- Emotional Intelligence: We recognize how fear and greed drive market behaviour, and help our clients act rationally when many others are swayed by emotions. We ensure you don’t make 30-year investment decisions based on the last 30 minutes of news.
- Bespoke Strategies: We provide all our clients with individualised investment strategies based on their needs, risk profiles, time frames and budgets. Clearly, this tailored approach will always outperform the typical one-size-fits-all methods.
Conclusion
The dynamic interplay between human psychology and investment markets offers us a fascinating window into both the human mind and our financial systems.
It reminds us that at the core of all the complex investment decisions lie our very human hopes, fears, and dreams.
And the imperfections in the residential real estate market create opportunities for those with the skills, knowledge, and strategies to exploit them.
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