Monday, October 19, 2009

Behavioural Finance - Effects on Housing

This is a decent background read on the implications of various studies on the housing market.


JimTan said...


This is heavy stuff and unsuitable for this forum. Does Mohican understand the traditional paradigm in the first place?

Anyway, this year validates the random walk hypothesis. Who anticipated that the financial markets would bottom in March? And, the RE market would surge in the summer.

buff_butler said...

I acutally find these papers really interesting and there doesn't seem to be many places on the internet for this type of stuff. The only problem is I typically have to read it over a couple days because of time constraints and by that time a new topic has started.

I laughed at the availability heuristic. Translated into the real estate world people are more likely to buy if the topic comes up more... hmmmm :P

I think the paper is interesting but lacks any real meat or conclutions regarding its topic. Given how long behavioral finance has been arround I'm supprised how little progress seems to have been made in the property market. However given you have so many differet types of buyers I would imagine this would be a difficult problem.

RentingSucks said...

Mohican has posted this before but if you like stuff like the above then you would probably also find the Psy-Fi blog interesting:

mohican said...

JT - that is a bit of a low blow there buddy. Why is contentt like this unsuitable for this forum? I think we have a pretty intelligent audience here and I also think we are all trying to wrestle with what makes markets, including the real estate market, behave the way they do.

It seems clear to me that CAPM, EMH, MPT fail to explain many of the behaviours and outcomes that we see in markets around the world. I am not proposing that we invalidate those theories, just that we could probably have a more informed opinion that includes analysis looking at the individual decision making processes and extrapolate how that may change the dynamics of a given market.

JimTan said...


Why is it a low blow?

Anyway, why don't you explain to us why the CAPM is inaqequate to explain the Vancouver RE market?

mohican said...

Let's try this for starters:

Assumptions of CAPM

All investors:

Aim to maximize economic utility.
Are rational and risk-averse.
Are price takers, i.e., they cannot influence prices.
Can lend and borrow unlimited under the risk free rate of interest.
Trade without transaction or taxation costs.
Deal with securities that are all highly divisible into small parcels.
Assume all information is at the same time available to all investors.
Perfect Competitive Markets

JimTan said...


As I expected, right out of the wiki article on CAPM in the section 'Assumptions of CAPM'.

There is no need for me to say anything further.

mohican said...

JT -

Do you have a problem with that?

Do you feel those assumptions are inaccurate?

Would you prefer a reference to something like this -

vibe said...

There is no need for me to say anything further.

Well there's something we can all agree on.

JimTan said...

Sorry, Mohican,

Your link doesn't work. Page not found?

Tony Danza said...

Thanks for the link Mo.

BTW JimTan is just a sad and lonely woman who never learned to play nicely with others, I for one feel sorry for her.

mohican said...

JimTan said...

Suggest you 'www' the link and let yahoo take you there.

Here are the interesting extracts. Note that I have used upper-case to emphasize the author's position. Any comments?

[Page 22] The conflict between the behavioral irrational pricing story and the rational risk story for the empirical failures of the CAPM leaves us at a timeworn impasse. Fama (1970) emphasizes that the hypothesis that prices properly reflect available information must be tested in the context of a model of expected returns, like the CAPM. Intuitively, to test whether prices are rational, one must take a stand on what the market is trying to do in setting prices, that is, what is risk and what is the relation between expected return and risk. Thus, when tests reject the CAPM, one can’t say whether the problem is its assumption that prices are rational (the behavioral view) OR VIOLATIONS OF OTHER ASSUMPTIONS THAT ARE ALSO NECESSARY TO PRODUCE THE CAPM (OUR POSITION).

[Page 25] We are more pragmatic. The relation between expected return and market beta of the CAPM is just the minimum variance condition that holds in any efficient portfolio, applied to the market portfolio. Thus, if we can find a market proxy that is on the minimum variance frontier, it can be used to describe differences in expected returns, and we would be happy to use it for this purpose. The strong rejections of the CAPM described above, however, say that researchers have not uncovered a reasonable market proxy that is close to the minimum variance frontier. And, if they are constrained to reasonable proxies, we doubt they ever will.

Our pessimism is fueled by several empirical results. Stambaugh (1982) tests the CAPM using a range of market portfolios that include, in addition to U.S. common stocks, corporate and government bonds, preferred stocks, real estate, and other consumer durables. He finds that tests of the CAPM are not sensitive to expanding the market proxy beyond common stocks, basically because the volatility of expanded market returns is dominated by the volatility of stock returns. One need not be convinced by Stambaugh’s results since his market proxies are limited to U.S. assets. If international capital markets are open and asset prices conform to an international version of the CAPM, the market portfolio should include international assets. Fama and French (1998) find, however, that betas for a global stock market portfolio cannot explain the high average returns observed around the world on stocks with high book-to-market or high earnings-price ratios. A major problem for the CAPM is that portfolios formed by sorting stocks on price ratios produce a wide range of average returns, but the average returns are not positively related to market betas (Lakonishok, Shleifer and Vishny, 1994, Fama and French, 1996, 1998).

[Page 28] The CAPM, like Markowitz’ (1952, 1959) portfolio model on which it is built, is nevertheless a theoretical tour de force. We continue to teach the CAPM as an introduction to the fundamental concepts of portfolio theory and asset pricing, to be built on by more complicated models like Merton’s (1973) ICAPM. But we also warn students that despite its seductive simplicity, the CAPM’s empirical problems probably invalidate its use in applications.

mohican said...

JT - I think you miss the point of what fama and french are saying when they propose a three factor model in place of CAPM and conclude that there are other additional factors that account for returns - momentum for example.

CAPM is simplistic and doesn't work. The Fama / French three factor model is the closest thing to efficient that we can get with any pricing model. If we look at the three factor model and what it means for vancouver real estate - the prospect for outsized returns is not good given the low Book to Market or high Price Earnings.

Additionally, even Fama and French conclude that there are other factors that determine short run returns that are not accounted for in the model. This is where I feel Behavioural Finance can really step in and help us explain what is going on.

Fundamentally, I agree with the Fama / French position on the three factor model over long periods of time. The factors they outline account for most long term returns.

markoz said...

I agree with BB. The concepts discussed are interesting but there is little meat on the bones. I am both fascinated by and fearful of the implications of behavioural finance. The fear relates to the idea that things are as valuable as people think they are. For example, I have always been mystified by how much value people attribute to gold. Its actual functional utility seems to have little relation to its "value". People have a psychological attachment to it going back thousands of years. You can't eat it, put it in your gas tank or shelter under it. Nonetheless it goes for close to $1000 an ounce. Similarly diamonds appear to have value far beyond their functional utility. That "value" seems highly dependent on the control of supply and a clever and longevous marketing scheme. What surprises me is not so much that these things can have exorbitant values placed on them, but just how long that perception of value can last. Tulips were worth a fortune until one day people realized they were just flowers. Gold, diamonds and (shudder) Vancouver RE seem to have an irrational grip with more staying power. Hope I'm wrong about Vancouver RE but it sure is depressing looking at the numbers these days.

JimTan said...

Hello Mohican,

I'm glad that we are in agreement that multiple factors influence prices. So, you should move beyond the simple one-factor regression analysis that you have been doing.

Second, don't assume that markets are irrational if your pricing model fails. This is F&F's position. It may be that the market is being driven by different factors.

In general, buyers/sellers are rational (risk averse) though they may not be numerate as we are. Behavioral studies help explain the decision making processes. [The irrational market researchers are only a small part of the total effort] In the end, GIGO. We are limited by the quality of the information we have access to.

Focus on GIGO. The American were caught by surprise because so much of the credit expansion was put into subprime mortgages and securitized (unregulated, unreported, unmonitored). The problem was not so much the sheer size of the credit explosion. The problem was how that money was used.

So, the crash was caused by a failure of market information efficiency. The market would be irrational if the information was known and ignored. But, that was not the case.

Indeed, a handful of traders did research and discovered the real state of affairs. They made big bucks being short. This is market inefficiency.

Canadians were operating under the same information conditions. But, there was no crash because the subprime mortgages were small. So, Canadian homeowners were rational and lucky.

Andy said...

What I understand of the current scenario is take a deep breath and watch the real estate market getting stabilized especially Laguna Beach Realty and then we can study the effects of other factors as well.

vibe said...

there was no crash because the subprime mortgages were small.

Are you sure about the subprime situation in Canada?

A crash is the natural consequence of a bubble. Subprime mortgages can exacerbate a housing bubble, but aren't necessary for a crash to occur. By what measure can you say that house prices were in a bubble in the US and not in Canada?

What pricing model can you propose that would justify current prices in Vancouver?

JimTan said...

I continued this discussion with Registered at RET.

JimTan said...

Let me finish up by offering this parable. 'A parable is a brief, succinct story, in prose or verse, that illustrates a moral or religious lesson.' (wikipedia)

I read about this experiment in my school days so long ago. The experiment was to test animals for problem solving skills. Food was placed behind a glass wall. A chimpanzee, puppy dog and farm chicken were positioned in front of the glass wall,

The chimp very quickly discovered that the only way to the food was to walk around the glass wall. The puppy was initially stymied by the wall. But, it observed and followed the chimp. Finally, the chicken kept trying to walk through the glass. It would have starved with food just inches away.

So, the parable is about those retards who lack problem solving skills AND refuse to follow the successful people. In the experiment, the loser was the chicken. In real life, the loser is ...

david said...

Yep jim I am the loser at 22 who is living comfortably for less than half of my monthly income. Oh how I long to be spending most of it paying off a mortgage for 25 years but I will have to settle for just renting for about 1/2 the cost.

JimTan said...


The issue for most buyers is their retirement nest egg. Can you double your principal every 10-15 years in the stock market. Would you go 80% leverage in stocks?

david said...


A house is a terrible vehicle for retirement savings. If you turn 60 and have peanuts in the bank but a fully paid off $1 million house what can you do?

Well you can sell it, but then you need some place to live, so you rent, or buy another smaller, cheaper place. Then with the leftover money you shove it in some sort of savings like stocks, bonds etc.

You could also do a reverse mortgage which I hear is a pretty big rip off but most people dont care because they want to keep living there but need money.

Finding investments that double in 10-15 years is not that hard. An investment yielding 6% would double in 12 years, and 6% usually is not hard to get. Just a few years ago GICs were paying around 5%.

And you really expect Vancouver homes to double in price in the next 10-15 years? That would put the average price of a Vancouver detatched home well over $1.7 million dollars. It will happen eventually but I think it will take a whole lot longer than 10 years.

I agree that owning a home by the time you retire is generally a good thing but to buy now and call it an investment is quite delusional in my opinion.

david said...

And Jim,

This graph

shows that from 1976 to now the average growth rate of house prices is 3.89%/year. That gives us a doubling time of just over 18 years. I am pretty sure the GIC average would be higher than that. Just this march I got a GIC of 3% and that is with historically low interest rates.

JimTan said...


Your house data is based on REAL appreciation. Do you have historical data about the REAL return on GIC, Compare apples to apples.

Thank You!

JimTan said...

Ohh! Profit from personal residence is tax free. What's your marginal tax rate on GIC?

david said...


Your right about the data being in real dollars, didnt notice that.

david said...

OK a more fair comparison.

shows homes in 1975 being about 60K in nominal dollars and about 720K ending 2007. A 12 fold increase.

shows the DOW in nominal monnies. 600 in 1975 and over 10K in 2007. A 17 fold increase. I am no stock expert but I believe there are dividends paid which dont show up here. I am not positive of this though.

And my GIC is in a TFSA so the gains are also tax free. I also have a bit in RRSPs which are taxed much lower when used properly. Hey! I could even use up to 25K of my RRSP to buy a house! Its win-win.

And only the principle residence has tax free gains. You mentioned you have an investment condo downtown a while back. When you sell that you will pay tax on the gains, as well as you should pay tax on the rent you collect (minus expenses, im not sure if that includes the mortgage).

However if we are talking about taxation, how about all the money you lose when you sell even a principle residence. Realtor fees, land transfer tax... it all adds up to around 7% of the total value of the property. If the place doubled in value that is a 14% loss on the gains.

JimTan said...


I don't have the time to hold your hand.

You remind me of Mohican. You keep messing around with numbers when you have no mastery over it.

What's the business sense of Vancouver RE investment? When is it a strategic investment? You are buying a scarce asset in a growing market. This will surely outperform GIC by miles in the long run, if you have an optimist's view of the future.

And, it will outperform the general stock market of an economy growing at 3% p.a.
Anyway this discussion is academic if your savings are low enough to fit within RRSP limits in the long run. Cheers!

david said...


I would agree that RE is a reasonable investment most of the time. It may not have the flexiblilty of stocks, GICs or bonds, but it is also a roof over your head, which is something you need anyway.

However I would be very hesitant to say that now is the time to consider RE in Vancouver a good investment. Prices at all time highs while interest rates are at all time lows. The only way for prices to climb higher would be a drastic increase in wages while interest rates remain low.

I do plan to become a home owner, probably in the next 5 years, but for now I think I am better off renting and saving up a bigger down payment.