Psychology and Property Purchase Decisions

Clare BraniganJune 2009

Research Question

• Are decision-makers making rational decisions when buying property?

Outline

• Traditional Economics

• Origins of Behavioural Biases

• Literature

• Dublin Property Market

• Studies: Hypotheses, Methodology, Results

• Contributions

The role of Traditional Economics

• Traditional economics theory is derived from neo-classical economics

– Decision makers are assumed rational utility maximisers

– They make unbiased forecasts about the future

Psychology & Decision Making?

• Decision Makers and investors are subject to decision errors and biases that result in the same mistakes repeatedly

2002 Nobel prize for economics

• Daniel Kahneman (with Amos Tversky)

– For integrating “insights from psychology into economics” (Royal Swedish Academy of Sciences citation)

2002 Nobel prize for economics

• Daniel Kahneman (with Amos Tversky)

– For integrating “insights from psychology into economics” (Royal Swedish Academy of Sciences citation)

– I.e., for challenging one of the most sacred precepts of economics that people make rational decisions

Origins of Behavioural Biases

1. Human Information Processing

– Too little or too much information will lead to errors

– Beyond an optimal point, more information leads to poorer decisions

– The Decision Maker becomes swamped, ignores further new information & ultimately random decision results

2. Heuristics

– We use heuristics or short cut rules of thumb & biases to simplify the complex judgement ore decision tasks that lead to cognitive errors (Tversky & Kahneman, Science, 1974)

3. Prospect Theory

– How we deal with “loss” in making choices in the face of risk & uncertainty (Kahneman & Tversky, Econemetrica, 1979)

Key Literature

Rationality Theory of Problem Solving Simon 1957, Tayler 1985

Decision Theory Utility Theory

Multi-Criteria Decision Making

Raiffa 1968, Saaty 1990, 1995,

von Winterfeldt 1986

Brugha 2001, 2004a, 2004b

Psychology/

Behavioural Effects

Self Control Issues

Cognitive Dissonance

Heuristics and Biases

Thaler, Shefrin, 1981

Akerlof, Dickens 1982

Kahneman, Tversky, 1979

Investing - Behavioural Effects

Escalation of Commitment*

Overconfidence*

Irrational Exuberance

Shortage Illusion

Arkes, Blumer(1985)

Barber & Odean(2001)

Shiller (2000)

Thaler (2000)

Auctions The Winner’s Curse* Thaler 1998, Bazerman 1993

Property Valuation Anchoring*

Valuations

Comparative Sales Methods

Northcraft & Neale(1987)

French & Byrne (1996)

Turner 1997

McGreal et al (1998)

The representativeness heuristic

• Judgements based on stereotypes – herd mentality

• Example

– Stockmarket reaction to dot.com firm name changes in the internet boom

– Insensitivity to prior information

- Market Bubbles

Anchoring & Adjustment

• Experiments demonstrate people will even anchor on a random number

Loss Aversion

• “Losses loom larger than gains”

• Loss aversion: people are more averse to losing something they own than they are pleased to make a gain (Thaler 1980)

• “Endowment effect” : we set a higher selling price on what we own (are endowed with) than what we would pay for the identical item if we did not own it.

Loss Aversion

• “Losses loom larger than gains”

• Loss aversion: people are more averse to losing something they own than they are pleased to make a gain (Thaler 1980)

• “Endowment effect” : we set a higher selling price on what we own (are endowed with) than what we would pay for the identical item if we did not own it.

• However, standard finance, teaches that prior losses are sunk costs & irrelevant

Loss Aversion

• “Losses loom larger than gains”

• Loss aversion: people are more averse to losing something they own than they are pleased to make a gain (Thaler 1980)

• “Endowment effect” : we set a higher selling price on what we own (are endowed with) than what we would pay for the identical item if we did not own it.

• However, standard finance, teaches that prior losses are sunk costs & irrelevant

• “The sunk-cost effect is an escalation of commitment & has been defined as the Greater tendency to continue an endeavor once an investment in money, time or effect has been made”. (Arkes, Blumer,1985)

Research Programmes

• Viewed over 200 properties

• Attended and collected data from 200 Auctions

• Analyse Data relating to 1565 auction results

Dublin Property Market

• Auction Room

– “Shortage Illusion” leads to Panic buying, price becomes irrelevant

– Sunk Costs (property survey, solicitor’s fees, time at previous auctions)

– Endowment Effect

– Escalation of Commitment - View auction room as a competition, “win” at any cost

– “Herd Mentality”

– Winner’s Curse

Samples

Belmont Ave, Donnybrook

Apr 05Guide €700,000

Belmont Ave, Donnybrook

Apr 05Guide €700,000

Sold €1.36 m, 4 bidders 94% over guide price

Temple Cresent, Blackrock

May 05Guide €650,000

Temple Cresent, Blackrock

May 05Guide €650,000Sold, €1.3 m, 5 bidders100% over guide

Priory Grove, Blackrock

March 05, €730,000

Priory Grove, Blackrock

•

April 06 ?

Priory Grove, Blackrock

•

April 06 €1.8m

Which biases could be tested in an Auction Situation?

• The Winner’s Curse

– Experienced Bidders vs. non-experienced bidders

• Anchoring

– Guide prices should correlate directly to Sales Results

• Escalation of Commitment

Methodology

• Between Sept 04 and November 05, observed 200 auctions

• 100 were sold at auction, by an average of 40% over the guide price - clear evidence of Winner’s Curse

Variables

• Guide Price

• Sale Price

• Price announced on the market

• No. of Bidders

• Progression of Bids

• Previous Advertisement and Newspaper Editorials

• Characteristics of House

• Comparable Sales

• Agent

Result

Average Bid

0

10

20

30

40

50

60

70

80

1 2 3 4 5 6 7

No. of Bidders

% o

ve

r G

uid

e

100 Auctions

#bidders Avr Winning Bid

(% over Guide)

2 26

3 35

4 42

5 67

6 73

The Role of Experienced Bidders

• Experienced bidders are less likely to be affected by the Winner’s Curse.

• The opposite is true:

– Property Investors paid 63% over the guide price vs. average of 40% over the guide price

The more bids a person makes, the more committed he becomes to winning the auction.

ESCALATION OF COMMITTMENT

High Guide prices provide better Sales Results at Property Auctions

• Theory: Property valuations are influenced by initial selling price, with high initial prices, resulting in high valuation and sales price. This is an “anchoring” affect.

• High Guide prices provide better Sales Results at Property Auctions

Data Gathered

• Data on over 1500 houses was collected between Sept 2004 and Nov 2005.

Summary: 1565 Auctions

Date Total %Sold %Prior %After %WithdrawnSep-04 146 37% 3% 17% 43%Oct-04 176 40% 5% 12% 43%Nov-04 72 32% 3% 18% 47%Dec-04 11 64% 0% 18% 18%Feb-05 44 50% 2% 25% 23%Mar-05 141 53% 1% 21% 25%Apr-05 146 42% 2% 25% 31%

May-05 204 42% 10% 20% 28%Jun-05 178 44% 6% 20% 31%Jul-05 39 38% 0% 21% 41%

Sep-05 168 36% 8% 15% 41%Oct-05 143 48% 1% 24% 27%Nov-05 97 45% 2% 13% 39%

1565 44% 3% 19% 34%

Low vs. High Guide Prices

• Choose a similar selection of houses within a four mile radius –Grouped houses together by type (townhouse, semi-detached, detached), area, size and condition

Semi-D Results Before After

• Low Guide: €554/sq ft €747/sq ft

• High Guide €618/sq ft €663/sq ft

Anchoring does not occur

Estimate of Guide Price

• Estate Agents deliberately underestimated the guide price

• Prior to auction, Estate Agents stated guide price was 10-15% below market value.

• At auction Market Price was actually 23% higher than guide price (for 61 cases out of 100 auctions that marker price was announced).

Explanation:

• Lower guide prices present lower barriers to entry, which encourage more bidders to become interested in the property

• The greater number of bidders the greater chance of higher estimates, therefore the greater likelihood of the winner’s curse

• Lower guide prices encourage more bidders to have sunk costs in terms of property surveys and legal checks

• This encourages participation in the auction which results in the endowment effect

• All of which results in higher sales prices

Contributions To Literature

THEORY Result

1: The “Winner’s Curse” is Evident at Public Auctions for Residential Property

Support

2: Experienced bidders are less likely to be affected by the “Winner’s Curse .

Not-Supported

3 The more bids a person makes, the more committed he becomes to winning the auction

Supported

4 High Guide Prices provide better sales results.

Not-Supported

Implications for the Economy

• Property - Important Sector of Economy , in 2005 construction employment accounted for 12 ½ % of total employment

• The Auction method contributed to huge price fluctuations and unrealistic valuations

– Houses in “South Dublin” had 8-10 times increase in value compared to Dublin average of 4 times

– Also influenced house valuations in rest of Dublin and nearby counties

• Previous studies on property auctions are limited

• Percentage of Auctions increased each year by 25%

– By 2006 - 1,400 houses were auctioned, the majority of second-hand residential homes in South Dublin

Contributions to Public Policy

• Transparency in Sales Results

All sales prices should be available in a public register, both auction prices and private treaty sales. Winner’s Curse known to be more prevalent in the absence of complete information Changes to Guide Prices

• Changes to Auction Policy

– Houses should have to adhere to certain criteria before they can be auctioned . Reserve Price should be used only.