The Psychology of the Housing Bubble

I was getting my hair cut yesterday, and the guy next to me was talking loudly about his upcoming weekend. He had chartered a private jet to take his girlfriend to Idaho for the weekend. This guy must have been in his mid-20s. He went on to explain that he'd been working in real estate for "a long time". He was having "a great run". He explained to the hairdresser that anyone could get into real estate, even without savings - "there is this great financing you can get", he told her with self-confidence.

Pundits talk a lot these days about the housing bubble. Excellent articles in The Economist ("After the fall", Jun 16th 2005) and The New York Times ("Is It Better to Buy or Rent?", Sep 25th 2005) demonstrate how real estate fundamentals cannot support current prices. Real estate in the coastal regions of the United States (particularly San Francisco, Boston, Los Angeles, New York, and Miami) and Europe (southern Spain) is overvalued and vulnerable to future price declines. Prices have been driven to these levels by fancy financing schemes, hopes of rapid capital appreciation, and the fear that "if I don't get in now, when will I ever?"

I got interested in financial bubbles during medical school, when the Nasdaq was soaring high with the internet mania. In fact, my "senior project" in medical school was to research the psychology of stock market bubbles. My faculty supervisor, Ernest Barratt, is the creator of eponymous "Barratt Impulsiveness Scale" - a widely used impulsivity measure. It turns out that impulsiveness (among other psychological traits) is directly related to how easily we are pulled into the "bubble mentality".

The recent price appreciation of real estate represents "irrational exuberance". But that'e easy for many people to identify. The hard part is timing an entry and exit, and knowing what the consequences of a deflating bubble will be for other industries.

To call the peak of a bubble, you've got to know what will deflate that exuberance (and prevent it from reflating). And you've got to understand how a bubble forms. But let's back up a for a minute. From a psychological perspective, how do we even know when we're in a bubble?

Bubbles usually start with good intentions. The internet stock bubble is an easy example. The internet is changing the world. But all those changes did not occur from 1997 through 1999.

People generally over-react when they get a string of good news. They start thinking, "the sky's the limit." And that's when the warning bells should go off. I've got a list of bubble prerequisites below. The financial fundamentals are often easy to measure. It's when the expectations of future returns, or the hope for short-term capital gain, inflate that we have to worry.

Below is a diagnostic chart to help understand when a bubble might form, whether in real estate, an entire industry, or an individual stock.

BUBBLE PREREQUISITES

FINANCIAL FUNDAMENTALS:
Low supply. Examples include:
The scarcity of homes in certain regions of the coasts
Stricter development regulations
Little or vague financial information available:
It is difficult to gauge market price changes
Realtors have an incentive to hide a softening market
Excess liquidity in the pockets of buyers
Low interest rates (and then interest-only loan payments)
Large capital gains have already been reaped by the "first-movers", and they're looking for new opportunities.

PSYCHOLOGICAL FUNDAMENTALS
Vividness of the concept
"I've got to have a roof over my head"
"I like real estate because you can see what you own"
Limited supply (Perception of scarcity)
"No more houses can be built on the coasts due to development restrictions"
Water-cooler or media frenzy: Groupthink and herding.
"You know, everybody's buying a house. Are you still a renter?"
Anticipatory emotions and impulsivity
Excitement about "getting rich" and fear of missing out.
Magnitude of potential payoff
"My friend made $300,000 after owning her house only one year."
Certainty of payoff
"Real estate has always gone up over any 5 year period. I'll just hold a few years if I have to."
Urgency
"You've got to get in now, since you don't know how long you'll be able to afford property around here"
Pursuit of gain (chasing)
Seminars on "How to get rich in real estate".
"It's proven, the surest way to wealth is real estate"

Now how do we know when the end is near?

Any stagnation or reversal in previously positive financial fundamentals paired with:
1) Historically high volume of turnover (already happening)
2) Positive expectations are disappointed in some investors (already happening)
3) Sellers begin dropping prices or relisting with other brokers (already happening)
4) Intense media focus (already happening) - but ironically, this is usually favorable coverage of the bubble - with real estate it has been unfavorable.

If you have any ideas or additions, please feel free to add them in the "comments" section below.

Richard