. There are four behavioural reasons why investors prefer residential investment property: perceived lower volatility due to the infrequency and inaccuracy of pricing; perceived informational advantage; representation heuristic; and herding.
. These biases distort investors' understanding of property (making it appear more attractive than other asset classes).
. Given the likely mean reversion of residential property, it is important for advisers to help clients see this investment in context to help them make better decisions about how to grow their long-term wealth.
Residential investment property has been among the best-performing asset classes over the past 20 years. Investors have benefited from prices doubling in the last six years. While some exposure to property makes sense, there are behavioural reasons why investors can be overexposed to this asset class.
This article follows an earlier one that examined the fundamental factors that have led to residential property being perceived by investors as a more attractive asset class than long-term returns warrant.
The conclusions were:
. investors have a misplaced bias towards property at the expense of other asset classes;
. the impressive recent performance of property was contrasted with longer-term data that showed property underperforming other asset classes; and
. property prices are distorted (on the upside) by changes in the composition of the median property price; the regularity and inaccuracy of pricing; and the loose regulatory framework that leads to statements being made about property that could not reasonably be made about other investments.
Behavioural finance demonstrates investor choices are skewed by the fact they dislike a loss more than the equivalent gain. This is termed loss aversion. As a consequence, investors tend to avoid investments with a high level of volatility to sidestep the emotional rollercoaster of ups and downs even if they are aware that over the long term the trend will be up.
There are four reasons why property is viewed differently - perceived lower volatility due to the infrequency of pricing; perceived informational advantage; representation heuristic; and herding.
The lack of regular pricing is advantageous. Median house price measures provided by various sources track price movements on a monthly and quarterly basis rather than weekly or daily. Add in the fact that for most people it is not easy to get a guide on the value of their specific property. The end result is that loss aversion is less of an issue as investors are less aware of the price fluctuations of their investment.
Investors are also more inclined to take a long-term view with property because they have usually signed on to a large loan.
The positive behavioural outcome is that people tend to stay the course with property, resulting in a decent long-term return, provided they have not paid over the odds on the purchase. Compare that with equities whose ups and downs are tracked in each day's paper and highlighted in the television and radio news, stoking the emotions of fear and greed that cause irrational investor actions.
Residential property offers investors a perceived informational advantage. Its tangibility conveys to investors a sense of knowledge, security and control.
This gives property the power to elicit a powerful emotional response that encourages investment.
Investors are also prone to overconfidence, making decisions based on representations. In his book, Irrational Exuberance, Yale University economics professor Robert Shiller says investors "make judgments in uncertain situations by looking for familiar patterns and assuming that future patterns will resemble past ones, often without sufficient consideration of the reasons for the pattern or the probability of the pattern repeating itself".
Australia's residential investment properties 'dream run' has occurred against a backdrop of an economy in its 15th year of economic expansion, record low unemployment, global interest rates at their lowest level in a century (2003) and state governments' failure to release enough land for development. It is uncertain whether any, or all, of these factors will remain in place in the years ahead.
The tendency to make the same mistake, at the same time (commonly referred to as herding) further complicates investment in residential property.
Herding is a form a momentum-based investment, without regard to valuation. Given the infrequency of pricing and illiquidity of the residential property market, herding is amplified and reversions to mean (equilibrium pricing) may often take years, in contrast with the swift reversions in equity markets. That is why property booms can result in painful financial outcomes for those that buy in at the peak, driven by emotion rather than sense.
In conclusion, residential property has a place in portfolios, however, owning the family home already provides some exposure. As with all investments, the risk is where you overdo exposure to one asset.
Advisers that understand the behavioural biases that have investors more inclined to invest in bricks and mortar, will be better placed for a deeper discussion with clients about how best to allocate their funds.
The financial services company has announced its FY22 results. ...
The government is planning to map out the future of the labour market. ...