Psychology and Property Purchase Decisions

1. Psychology and Property Purchase Decisions Clare Branigan June 2009

2. Research Question • Are decision-makers making rational decisions when buying property?

3. Outline • Traditional Economics • Origins of Behavioural Biases • Literature • Dublin Property Market • Studies: Hypotheses, Methodology, Results • Contributions

4. 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

5. Psychology & Decision Making? • Decision Makers and investors are subject to decision errors and biases that result in the same mistakes repeatedly

6. 2002 Nobel prize for economics • Daniel Kahneman (with Amos Tversky) • For integrating “insights from psychology into economics” (Royal Swedish Academy of Sciences citation)

7. 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

8. 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)

9. Key Literature

10. 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

11. Anchoring & Adjustment • Experiments demonstrate people will even anchor on a random number

12. 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.

13. 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

14. 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)

15. Research Programmes • Viewed over 200 properties • Attended and collected data from 200 Auctions • Analyse Data relating to 1565 auction results

16. 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

17. Samples

18. Belmont Ave, Donnybrook Apr 05 Guide €700,000

19. Belmont Ave, Donnybrook Apr 05 Guide €700,000 Sold €1.36 m, 4 bidders 94% over guide price

20. Temple Cresent, Blackrock May 05 Guide €650,000

21. Temple Cresent, Blackrock May 05 Guide €650,000 Sold, €1.3 m, 5 bidders 100% over guide

22. Priory Grove, Blackrock March 05, €730,000

23. Priory Grove, Blackrock April 06 ?

24. Priory Grove, Blackrock April 06 €1.8m

25. 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

26. 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

27. 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

28. Result 100 Auctions #bidders Avr Winning Bid (% over Guide) 2 26 3 35 4 42 5 67 6 73

29. 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

30. ESCALATION OF COMMITTMENT The more bids a person makes, the more committed he becomes to winning the auction.

31. 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

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

33. Summary: 1565 Auctions

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 ResultsBeforeAfter • Low Guide: €554/sq ft €747/sq ft • High Guide €618/sq ft €663/sq ft Anchoring does not occur

35. 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).

36. 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

37. Contributions To Literature

38. 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

39. 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.