What Role Do Behavioral Biases Play with Real Estate Investments?

Many pride themselves in their extraordinary abilities to spot and exploit real estate investing opportunities.  Can they build returns sufficient to justify the inherent risk or is this flawed thinking?

Let's lay the foundation, academic studies have shown several behavioral biases are apparent when it comes to real estate investing.  I'm going to list a few below:

• Conservatism bias – This occurs when investors underweight and are slow to react to new information. For example, you are buying a car, everything looks good but right before you purchase the car, you notice it is missing a motor (extreme example I know). In this case you would use this new information and the result may be a trip home in your old 2004 Camry. However, it has been observed that real estate investors tend to react slowly and do not fully incorporate all new information into their decisions (Fu and Ng, 2001; Byrne et al., 2013). For example, the Fed may hike rates aggressively which impacts demand by raising mortgage rates and the opportunity cost of your investment. However, many neglect this information and move forward with their purchase - Blissful ignorance.

• Overconfidence bias – Characterized by one overestimating their abilities. Do you think you could consistently beat Tiger Woods in golf? In studies, we find that non-professional investors exhibit more confidence in their ability to select outperforming real estate investments than institutional real estate money managers (i.e. professionals)? It is also interesting that these non-professionals become significantly more confident after just one successful sale. (Clayton, 1997)

• Mental accounting – When individuals treat human capital (i.e. their income), stock market investments, and real estate differently with varying degrees of risk and treat each decision as one that is separate from the others. I see this all the time. An individual will be scared to lose 5% in the stock market but they are willing to invest a significant amount of their savings in a real estate investment where they can easily lose 5%. By separating these decisions, you may expose your net worth to greater risk, less diversification, and may possibly come up short of your financial goals. (Thaler, 1985 & 1999)

• Familiarity bias – People tend to invest in what they are familiar with. Even Warren Buffet said, "Invest in what you know," but I would be surprised if Mr. Buffet was "familiar with" all of the investments in his portfolio (e.g. GlaxoSmithKline, Sanofi Aventis, Synchrony Financial, etc.). This advice presents a problem for professionals in the industry. Often, you will see mortgage brokers and real estate agents invest a significant amount of their wealth in real estate. But I ask, if you are a real estate agent, and your livelihood depends on the health of the real estate market, shouldn’t you invest your savings in an investment that is not correlated with real estate? That is logical, but it is common to see real estate agents invest a sizeable amount in real estate, only to experience a period where they have no income, their real estate investments have lost value, and they have no liquidity because it is tied up in real estate. We also see familiarity bias exhibited in the stock market, where people tend to invest primarily in their home country. Sweden's stock market makes up ~1% of the total global market, but Swedish investors have about 55% of their portfolios in Swedish companies. In Japan, Japanese investors have over 90% in domestic securities (Betterment, 2016, https://bit.ly/2wn4x6O). Real estate investors also demonstrate this bias when they primarily invest near their home and believe that market offers the best opportunity. Meanwhile, they fail to diversify and evaluate other markets for opportunities (Huberman, 2001). If everyone believes their home market is the best opportunity, then who is wrong?

I live in Denver, and hear that Denver's market is insulated and does not fall like other markets.  To those who believe this is the case, have you considered this could mean Denver's market has more room to fall?

Does Denver's market offer the best opportunity?

Given these biases, ask yourself, is real estate the best opportunity for your savings?

Below, you can observe the total returns of real estate since 1987 after adjusting for inflation (measured by the CPI-U).  

Many present me with the argument that real estate is levered since you only have to put a portion of the value down (stock investment can also be levered but we will ignore that).  Below, you can see how real estate has fared when factoring in leverage and assuming a down payment of only 20%.  

I would encourage you to consider these biases and self-reflect to see if you suffer from any of them.  If so, mitigate the risk of making a costly mistake by seeking out information that is contrary to your beliefs.