Why do economists get their property predictions so wrong?

If our economists are armed with all the research available in today’s information age, why can’t they agree on where our economy and property markets are heading?

In fact, a better question would be: Why do so many get it wrong?

The simple answer is that market movements are far from an exact science.

It’s more than just fundamentals that move markets

The fundamentals are easy to monitor. Things like population growth, supply and demand, employment levels, interest rates, affordability and inflationary pressures.

However, one overriding factor that the experts have difficulty quantifying is investor sentiment.

Market “madness” plays a big factor

In a recent report, Dr Shane Oliver, AMP’s chief economist explains that people often suffer lapses of logic when investing and many of their investment decisions are driven by emotion.

For example, we tend to extrapolate the present in the future. When things are booming we think the good times will never end and when the market mood is glum, we have difficulty seeing the light at the end of the tunnel.

Think about it. When the media reports falling property prices or an impending housing crash, many investors become scared and sit on the sidelines, believing the end of property is nigh and things will never improve, when in reality much of the risk has been removed from the market.

Conversely, when property markets are booming and stories of investors seemingly making large gains overnight abound, people want to jump on the bandwagon and cash in, often at a time when the market is near its peak.

Other emotional traps include becoming overconfident, wishful thinking and ignoring information that conflicts with your current views. In other words, many investors create their own “reality.”

Can you see how this type of activity, influenced by investor psychology, drives booms and busts? How the dominant investor mentality of the time helps drive the property cycle?

Simply, when investors put on the brakes, housing values tend to stagnate or fall due to lack of demand. And when they jump back into the market, demand rises and up go prices.

Obviously, one or two misguided investors won’t be able to influence property prices, but investor sentiment is contagious.

People tend to want to do what others are doing. They ‘follow the crowd’ because going against popular opinion is seen as risky. What if you make a mistake? What if the others are right and you are wrong?

Oliver says this “collective behaviour” is magnified by several things, including:

• Mass communication enabling the behaviour to become infectious. Now more than ever we are bombarded with messages from the media influencing how we think and feel about things. When we hear that real estate is doomed, all but a handful of sophisticated investors get scared out of the game. And when the media tells us housing markets are booming everyone wants a piece of the action.
• Pressure to conform. If your friends or family are doing it, it must be right. Right? Human nature makes us reluctant to do the opposite of what our peers are doing.
• A major precipitating event can give rise to a general belief that motivates investor behaviour. The global financial crisis saw waves of investors scared out of the markets. On the other hand, the resource boom enticed thousands of investors into west coast housing markets to cash in on the resulting property boom.
• A general belief that grows and spreads. When the belief that property values can only go up spreads through an uneducated new generation of investors they enter the market, pushing prices up even further, perpetuating the belief and helping make it a reality! Similarly, when the crowd believes the market is going to crash, they steer clear. This gets reported in the media and the negative sentiment feeds on itself.

Oliver observes that these “lapses in logic” by individual investors and the magnification of such lapses by crowd psychology feeds property cycles and goes a long way in explaining why we see boom and slumps at different points in time.

When investor sentiment is positive, the crowd jumps in feet first, pushes up demand and places upward pressure on prices – causing boom conditions. Conversely, when sentiment is negative, the crowd backs off and frequently sells out of the game due to concerns that they’re about to lose everything – causing market slumps.

What can an investor learn from this?

1. Our property markets are not only driven by fundamentals, but also by the often irrational and erratic behaviour of an unstable crowd of other investors.

2. Booms never last forever, neither do busts. Don’t be surprised when they come around and don’t overreact. According to Oliver, this will help you avoid being sucked into booms and spat out during busts.

3. Treat your property investments like a business and stick to a proven strategy to take the emotions out of your investment decisions.

4. Recognise that property is a long-term play and set up financial buffers to help you ride the property cycles.

Invest countercyclically

Warren Buffet once said: “We attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

This is also the investment strategy of many successful property investors.

I’ve always been an advocate of countercyclical investing. I’m often sceptical of conventional wisdom – not because the crowd is always wrong but because the crowd is always late.

Sure, it takes some courage to do the opposite of what everyone else is doing, but the results of your contrary behaviour will ultimately speak for themselves.

I’ll be explaining what I see happening in the short term at my National Property Market and Economic Updates around Australia next month. Click here for details. It would be great if you could join me.

Michael Yardney is the director of Metropole Property Investment Strategists, a best-selling author and one of Australia’s leading experts in wealth creation through property. For more information about Michael, visit www.metropole.com.au and www.PropertyUpdate.com.au.