Background: A plethora of non-cognitive factors, behavioural biases and general risk tendencies affect investment decisions in real estate and identifying these factors can have significant repercussions in the enhancement of real estate decisions. Previous studies have shown domain general risk tolerance, the multifaceted personality factor and behavioural biases to be influential components for investment decisions. The motivation for this research is to investigate the novel and inter-correlated effect of key personality traits (openness to experience, conscientiousness, agreeableness, extraversion ad neuroticism), risk tolerance (domain general and domain specific) and behavioural biases (loss aversion and prospect theory) on the decision making concerning real estate investment and to ascertain the gender differences in the tolerance for risk. Furthermore, to determine what predicts risk in decision making and therefore facilitate the most beneficial and informed investment decisions and create optimum portfolios.
Aims: The aim of this paper is to provide a novel contribution to our understanding of what determines individual risk taking in the financial domain. The current investigation uses a correlational analysis to evaluate the unique and combined contributions of the independent variables (domain general risk tolerance, personality, loss aversion) on the dependent variable (risk tolerance in real estate decisions)
Method and Procedures: A group of males and females (50 participants) from a range of demographics (with the requirement of having completed an undergraduate degree) completed subjective self-report questionnaires delivered online via a recruitment link using the program Qualtrics (www.qualtrics.co.uk).
Outcome and Results: Results of correlation analysis showed significant positive associations between domain general risk taking, openness, extraversion and loss aversion with the real estate investment outcome measure. A negative relationship was also evident between agreeableness and neuroticism with the outcome variable. The regression analysis indicated that domain general risk taking predicted real estate investment decisions. Furthermore, there were significant gender differences in the tolerance for risk.
Implications and limitations: Limitations of the study are noted – most critically the potential small sample size and the unreliable nature of self-reported subjective data. Implications are far reaching and the potential three stage model of investment decision making is discussed.
2.0 General introduction
Recently, research has shown that real estate is a fertile ground for non-cognitive influences and value can be gained in adopting a more behavioural approach to investing in the asset class (Fidelity, 2018). This approach understands that views, actions and individual differences of participants of the real estate market can have a significant effect on market direction and fundamentals.
The classical financial model suggests efficient markets and rational investors, but the behavioural finance model provides a more flexible framework which can account for the reality of booms and busts which occur in financial markets. This model sheds light onto the market pricing swings due to biases and herding. With the busts playing such a critical role in the economy, from Tulip Mainia (1630’s) to the Global Financial Crisis (2008), investors continue to make irrational decisions burdened with human error. Thus, a successful framework in real estate investing must be flexible and must encompass human nature utilising behavioural finance as an important investment tool. ‘Markets are not machines nor closed systems, rather they are manned by humans. It follows then that the way in which markets work can only be fully explained by a model that encompasses human nature itself’ (Hong & Stein, 2003). Therefore, the current research will investigate the behavioural biases, individual differences such as personality, and domain specific risk and domain general risk to ascertain the relationships between these influential factors and real estate investment.
There has been a growing interest in the intersection of behavioural economics and investment decisions, which indicates that the decision-making process is not rational but influenced by a multitude of subconscious factors (Khaneman, 2013). These social, emotional and cognitive factors could affect a person’s financial decisions and influence their investment success. In real estate investment choices, it is crucial to have awareness of these individual differences in the decision-making process. Additionally, findings from recent literature (Almlund et al., 2011; Rustichini et al., 2012) reveal the influence of non-cognitive factors, such as personality traits and individual differences in specific risk propensity in the decision-making process when investment risk is involved. It is important to note, as Yook and Everett (2003) argue, modern portfolio theory holds that optimal asset allocation in an investment portfolio must take into account the trade-off between expected return and risk, and accepts that individual investors have risk preferences that affect this optimisation (Hallahan, Faff, & McKenzie, 2004). These differences must thus be analysed in order to make the most well-informed decisions by being aware of the influences which affect them.
Furthermore, individual differences in risk tolerance have been evident in the past literature, rather than a domain general ‘risky’ personality, investment risk has emerged as a separate factor which correlates with real investment decisions (Corter & Chen 2006), however the notion of the instability of cross-domain risk preferences has differing opinions (Weber & Milliman, 1997). This risk adversity, or lack of it will be measured in the current study and relationships between real estate investment decisions and the different facets of personality will be explored alongside the influence of behavioural biases which have been shown to influence investment decisions with regards to risk.
2.1 Behavioural biases
Research from behavioural psychology suggests our brains have two cognitive decision- making systems, fast-thinking system one and slow-thinking System two (Khaneman and Tversky, 1979). System one is more automatic and operates on a subconscious level, it is related to the fight or flight response with speed of reaction at the focus, becoming particularly useful in times of threat. The system two, is more rational, and used when calculation and deliberation is required (Figure 1).
From experiments investigating these two systems during investment decisions, investors have been shown to revert to the automatic more irrational route of decision making during time of stress and uncertainty to avoid the cognitive overload of system two. This is relevant in real estate
investment decision, as in times of stress, these behavioural can unconsciously affect our system one thinking, and combined with a lack of system two rationalisation, can lead to suboptimal real estate decisions (Fidelity, 2017). Importantly, instinct and emotions override login during a crisis.
The behavioural finance model allows a more mobile framework which allows for the rises and falls of the investment market rather that the rigid classical financial model which assumes efficient markets and rational investors. The decision-making process is not rational but influenced by a multitude of subconscious factors and specifically, cognitive errors are evident in the real estate market due to specific features of the asset class (Fidelity, 2017). These features include: higher level of market inefficiency; lower levels of information transparency; the inability to take a short position; illiquidity and emotional attachment due to inherently tangible nature of the asset class. Market inefficiency occurs in real estate as there is greater levels
of information inconsistency between market participants and greater dependency on market intermediaries. Secondly, the inability to short means markets can be more prone to sustained moves away from fair value. In a more efficient market, excessive optimism would be moderated by other investors taking a short position. Information is not transparent, with deals typically struck via individual negotiations between buyers and sellers; since there is no central exchange, sellers typically know more about assets than buyers. Furthermore, illiquidity occurs as properties are traded infrequently relative to other asset classes; the heterogeneity of the asset class (the fact that each property is unique) contributes to the illiquidity. Also, a key factor affecting the rationality of real estate decisions is investor perception, with real estate remaining a generally misunderstood investment invariably bought for capital growth even though income drives the majority of returns. Indeed, in western developed markets, income typically drives between 65% and 80% of 20-year total returns (Fidelity, 2017). These factors all contribute to the
Due to the growth of transparency, analysing and forecasting (through MSCI), improved market information and property indices, the data can now be analysed to ascertain the relevance of these unconscious biases on real estate decision making. The main behavioural biases evident in the real estate investment include: framing bias, anchoring bias, loss aversion, home bias and herding bias.
• The ‘framing bias’ – “the average market return is impossible to access – it is not an achievable investment target”. This makes traditional asset allocation models all but redundant.
• The ‘anchoring bias’ – this often occurs when investors fixate on capital gains and not the income return element of the asset class which makes for suboptimal decision making.
• ‘Loss aversion’ – Loss aversion states that losses loom larger than gains and thus an investor is more likely to take a risk when a loss is involved as opposed to a gain.
• The ‘home bias’ – this is evident when investors tend to place more of their portfolio in their home country due to familiarity and lose out on the opportunity cost and sacrifice better returns and diversification of investing abroad
• The ‘herding bias’ – In real estate, it is dangerous and creates the asset classes cyclical nature when investors herd together to invest in the same sector and country, thus overinflating that market.
The current study will focus on the behavioural bias of loss aversion and home bias and how this is linked to the tolerance for risk in the real estate investment decision.