One of humans great behavioural benefit and flaw at the same time is its wanting to be positive and expect good things to continue.  We have cognitive bias’, with herding being a big part of it.  We are always looking for information that supports our beliefs and with the amount of available information sources, supporting your thoughts is not hard to find.  The problem is that with asset values and bubbles, our minds do not want to see what is rational, as recent history is expected to continue.  Let’s look at today’s real estate and stock markets and see how these principals apply…..

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First, let’s look at how our minds get in the way of our financial success.  At least, it prevents us from being as financially successful as possible.  We have many times discussed how at asset bubble peaks (stocks, bonds and real estate), investors are at a peak state of optimism, with greed being the underlying theme for investing.  Rational analysis does not make sense, as the trend up has been too good so why fight a good thing.  The problem is that all trends in and bubbles end badly.  Most of the time they end up deflating to where the bubble started.

Of course, the opposite is the case at market bottoms.  Once we have gone through a crash in any of the assets mentioned, optimism turns to pessimism.  Greed turns to fear.  Few want to invest, and many actually want to get out of the underlying investments they own as they expect the bottom of the cycle only to be on the way to the ultimate bottom.  Any rallies are perceived to be as false rallies, as anger and disbelief surround asset price movement.

Let’s look at a number of the mental factors that impact most individuals with their investment decisions:

  1. We tend to surround ourself with information that supports our beliefs.  The one thing you can find is someone to back up your opinion in the information age.  Also, most individuals have similar views in assets such as real estate and stocks, including the media, so you do not have to go too far to find supportive information
  2. The anchoring effect – where humans focus on specific value of an asset, comparing it to other options. They do this instead of determining the valuation of each asset class separately. We are living through the perfect example today where few sit in cash investments as the return is basically zero.  Instead, they want to be invested in stocks or real estate as the perceived gains will be higher, independent of the underlying valuation of the assets
  3. People tend to believe their memories more than facts.  This is a reality, and we fight it all the time as financial coaches. We believe that we present strong logical arguments, but many do not want to hear logic as their recent experiences (memories) have been positive.  Also, most will make base decisions on recent memories, not longer term. It is funny when we ask investors to reflect back on 200-02 and 2007-09.  Many have pushed these longer term memories out of their mind and do not think such times can repeat themselves
  4. We all have cognitive bias’ which lead us to systematic deviations from a standard of rationality or good judgement.  In other words, sound judgement becomes irrelevant.
  5. Confirmation (or confirmatory) bias is the tendency to search for, interpret, favour, and recall information in a way that confirms one’s preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities.  No one wants to think things can go from good to bad, so they will find and recall information to confirm their current beliefs.  Why do things have to change?  Unfortunately, they always do, as we have to go through good and bad periods on an ongoing basis
  6. Another bias is Optimism bias, which is where one’s judgement is greater than objective accuracy.  Forget about truths, history or analysis.  All that matters to many is their judgement even if it is totally irrational.
  7. Loss aversion and also loss of profits aversion means investors will want to stay invested at the top and not invest at the bottom.  Greed and fear dictate these emotions
  8. Herding is a reality that happens all the time.  There are few leaders, but once they start a trend, most love to jump on that bandwagon once it is proven to be successful. The problem is that most herd way too late into a trend and end up losing a great deal of money via asset deflation.
  9. People prefer stories to analysis.  This is another challenge for investors as it is easy to talk about how an investor made millions from stocks or real estate, and you want the same.  Stories like this draw investors in and they are huge winners for manipulative marketers.
  10. Projection bias is where individuals picture themselves in the future being the next story of wealth.  They borrow to the max near peaks and expect to make returns that those made who did it early in the cycle. Instead, they are on a path towards bankruptcy.

Let’s now look at real estate and see if it fits into this model.  Here is a chart that looks at the Canadian market where data starts in 1990, with data prior to that assuming the Canadian market performed like the US market:

Shiller-Canadian-house-price-chart-update-650x482

Does the current run-up look like a bubble relative to the history of real estate prices?  If it looks like a bubble, smells like a bubble, it probably is a bubble.  Unless we are in a new paradigm, the current soaring of real estate prices is nothing but a bubble waiting to burst.  Read the ten mental barriers to logical decisions again, and you will see many of the realities fit in with today’s market.  People do not want to look at reality like we have shut out the next generation from real estate purchases which cannot occur; that interest rates at near zero cannot stay there forever; that debt being so easily available will not always be the case once we hit a credit crunch.

Look at the crash in prices in the early 1900’s – down nearly 50%.  This can happen and does happen, especially after a good run up like we saw prior to that crash.  The market ran up about 40% in about five years – sound like today’s market?  Look at how real estate performed for five decades, from post-WW II until the early 2000’s – the price of real estate adjusted for inflation, basically did nothing.  Now look at the run up since 2003 – it is up over 80% and in major markets like Toronto and Vancouver, much more than that.  That is not healthy, and inevitably, it will correct and probably significantly.

Lets now look at a chart of US home prices adjusted for inflation from 1890 to current:

Real-US-home-prices-1890-20142

The movement in US real estate in the early part of the 2000’s was nearly completely retraced.  The market crashed by 42%. Yes, we have seen a minor rally since then, but there are many brilliant analysts that think this was a normal retracement of some of the loss before the market turns down again.  What has driven much of the current rally in prices – institutional buying, and that is not a positive trend as home ownership should be driven by the population, not corporations.  We think that before the current correction in real estate prices is finished, it will start where it began.  That means that US real estate prices could still correct by about 35%.  It is normal, but people forget what is normal because all they want to see is extrapolating current gains into the future, no matter how illogical it is.

Let’s look at the main stages in a bubble:

Stages of a Bubble

We won’t go through the chart in detail as it is self-explanatory in many ways, but we will look at the big picture pieces.  A bubble starts, post a correction or crash.  You get the initial Stealth Phase where only ‘Smart Money’ invests.  Clearly, it is the time where the most money is made as you are buying at the beginning of an up cycle.  The Awareness Phase is where institutions finally get comfortable enough to invest, still a good time.  The Mania Phase where things get out of control and the public gets invested, many of which do it in the second half of this phase, the worst time to invest.  Delusion is part of the paradigm, which fits in perfectly with our list of 10 factors above where our minds fool us.  Post the major run up; a correction occurs, a modest bounce (bull trap), then the big crash occurs.  Losses are huge, and the world ends up saying, why did we think like we thought, it made no sense.

A perfect example is the technology bubble in the 1990’s.  Here is a chart:

Tech-Bubble-Jan-94-to-Oct-02

The chart above represents the NASDAQ Composite which is an index of nearly 4,000 companies, almost two-thirds of which are technology companies. It covers the period from January 1, 1994, to October 9, 2002. I have also separated the tech bubble into the four phases which are typically found during an asset bubble.The chart of three phases in the bubble – Stealth, Awareness and Mania phases are sometimes broken into four phases. In Phase I, the smart money, as it’s sometimes called, invests. In Phase II, institutional investors begin to invest, and the bubble is now starting to form. In Phase III, the general public begins to notice and starts to invest. By Phase IV, everybody knows the asset price movement (in this case technology stocks) as the news media is proclaiming the benefits of this incredible investment. This is also the phase when those who were sitting on the sidelines decide to jump in.  It is during this final phase that the greatest amount of money is invested, and the rise is the steepest. The people who are hurt the most are those who remain invested during the fall, which

Logic is irrelevant here.  It comes down to herding or in otherwise following the significant trend. It is during this final phase that the greatest amount of money is invested, and the rise is the steepest. The people who are hurt the most are those who remain invested during the fall, which is often those who invested during the final phase. This is also the group that tends to repeat their actions during a subsequent bubble, time and time again.  Sadly, even those who invested early in the cycle, many times are oblivious to the trend ending.  They ride it out way too long and lose a lot of their gains.

Knowledge is power and understanding how our minds can fool us is a powerful knowledge to have. Invest differently than the masses and your wealth will soar.

Matt Sammut
Chief Investment Strategist
Fortrus Financial Coaching