Irrationality of Investors

The underlying price of any asset is determined by the simple economic laws of demand and supply. If we apply this principle in the case of house prices we should conclude that the current price is that set by market forces and therefore should be close to the assets intrinsic value based on the fundamentals of the economy at the time. However in order to understand how this principle is violated and ultimately results in a bubble we must examine in detail the factors which can influence demand and supply. 

During the US housing boom it is safe to say that demand for property was at an all-time high. The government was actively encouraging first time buyers (all too often subprime borrowers) to make a move onto the property ladder and developers were purchasing investment properties with a view to let or sell the property in the future at a profit. The ability of the demand side to increase so dramatically was fuelled heavily by the availability of easy and cheap credit. Easy meaning that almost anyone could successfully apply for a mortgage (this lead to the widely used term ‘NINJA’ – No income, no job or assets) and cheap meaning low interest rates or interest only mortgages.

Allen and Gale (2000) point to the ability of borrowers to risk-shift as a major contributing factor to asset price bubbles. Borrowers can easily obtain funds and then invest in projects which will deliver the greatest return and because lenders cannot easily observe the riskiness of a project, there is an agency problem. However in the case of the housing bubble lenders felt that any project involving property was low risk as property prices had been increasing for many years and it was not uncommon for lenders to provide 110% - 120% mortgages.

It can be argued that this boom in demand was also caused by the psychological failings of investors and thus lead to irrational behaviour. Investors in property were over-confident about their predictions of the future. Simple terminology such as referring to a second home as an investment property instead of what it truly was – a speculative purchase, led many investors to feel they were guaranteed a profit. They also either, overestimated their ability to make repayments on mortgages or they predicted that house prices would continue to rise forever and it was therefore impossible for them to lose. There is also the idea of herding, whereby investors simply seen other people profiting from the housing boom and therefore decided to follow suit with little understanding of the market or actual risks involved.

It isn’t difficult to see how these factors influenced demand in the housing market and how this shift in demand was built on poor economic foundations. In my next post I will discuss the contribution made by the Federal Reserve towards the housing bubble and what if anything they could have done differently.

"Investors should try to be fearful when others are greedy and greedy when others are fearful" Warren Buffet 2004