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«Abstract This study empirically exams the combination of regret aversion and false reference points in a residential real estate context. Survey ...»

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Regret Aversion and False Reference

Points in Residential Real Estate

Authors M i c h a e l J. S e i l e r, Vi c ky L. S e i l e r, S t e fa n

Tr a u b, a n d D av i d M. H a r r i s o n


This study empirically exams the combination of regret aversion

and false reference points in a residential real estate context.

Survey respondents were put in a hypothetical situation, where

they had purchased an investment property several years ago.

Hindsight knowledge about a foregone all time high was introduced. As hypothesized, respondents on average expressed higher regret if they had actively failed to sell at the all time high (commission scenario) than if they had simply been unaware of the potential gain (omission scenario). Women were found to be more susceptible to regret aversion and false reference points than men.

Traditional financial theory approaches decision making from a very mathematical and logical standpoint. The reality, however, is that people make financial decisions. So no matter how quantitative and objective financial models are constructed, people must ultimately make buy and sell decisions. This melding together of mathematics and psychology is known as behavioral finance.

The few studies that use behavioral concepts in real estate have centered primarily on anchoring bias. Anchoring is the notion that people tend not to deviate from a given starting point even if new information dictates they should. For example, Northcraft and Neale (1987) found that once a starting price is given, even real estate professionals suffer from anchoring bias when valuing a home. This bias persists both when the anchor is generated externally and when the prior prices are provided by the appraiser themselves (Geltner, 1993; and Diaz and Hansz, 1997).

The purpose of this study is to test additional behavioral finance theories in a real estate context. That is, this study examines two prevalent psychological biases that are hypothesized to cause real estate investors to deviate from purely mathematical thought processes. Specifically, regret aversion and false reference points are empirically tested.

JRER Vol. 30 No. 4 – 2008 462 Seiler, Seiler, Traub, and Harrison Literature Review Regret aversion refers to the phenomenon that people keep the status quo because they know from experience that options that seem to be favorable given the apparently correct information at the time the decision is to be made, may later turn out to be less favorable than previously assumed (Samuelson and Zeckhauser, 1988). Regret aversion therefore is closely linked to the theory of omission bias, which holds that people perceive harmful commissions as worse than corresponding omissions and, therefore, prefer omission to commission (Ritov and Baron, 1992). Selection of an alternative also means commitment to the alternative. Psychological commitment claims behavior on behalf of a position, as a change may damage self-esteem.1 When a poor decision is undeniable to ourselves, the natural survival instinct is to downplay the importance of the event or change the way we think about the outcome altogether. That is, we change the reference point from which the outcome is evaluated.2 As Arkes and Blumer (1985) emphasized, upward re-evaluation of the chosen alternative may result in an increased willingness to spend further effort on the alternative as compared to the resources that would have been spent voluntarily if no prior commitment had been made.

In their extensive study on status quo bias, Samuelson and Zeckhauser (1988) collected anecdotal evidence, field experiments, and a number of laboratory experiments. A striking example of ‘‘real world’’ status quo bias is that of a small town in Germany that had to be relocated due to a mining project. As Samuelson and Zeckhauser reported, ‘‘Government specialists suggested scores of town planning options, but the townspeople selected a plan extraordinarily like the serpentine layout of the old town—a layout that had evolved over centuries without (conscious) rhyme or reason’’ (p. 10). In their field studies, Samuelson and Zeckhauser were able to demonstrate status quo bias, for instance, for the enrollment of Harvard employees to health plans.3 A pooled regression based on the data of all their laboratory experiments (concerned with a variety of topics such as automobile safety) revealed that the probability of the status quo alternative to be chosen is significantly higher than a non-status quo alternative and that the prevalence of the status quo alternative increases with the number of options. For example, in a presidential election with only two (otherwise identical) candidates, the incumbent office holder could expect about 58.5% of the votes (a relative benefit of 17%). If the number of candidates increased to four, the predicted voters’ share of the incumbent would be 37.75%, that is, a relative advantage of 51% as compared to his ‘‘natural’’ share of 25% (see also Traub, 1999, p. 80).

Quite naturally, strong evidence for regret aversion and false reference points has been reported in risky choice. Kahneman and Riepe (1998) provide a survey of biases of judgment and decision making that can appear in the context of financial investments. Consider a common stock example. Odean (1998) found that when investors need to liquidate stock, they are 1.5 times more likely to sell the one Regret Aversion and False Reference Points 463 that has gone up in value. Doing so locks in the confirmation that they made the correct purchase decision. Further, Shefrin and Statman (1985) concluded that people hold onto stocks that are losers far too long and sell winners far too quickly.

Both of these tendencies translate into poor investment buy/sell rules. So the conclusion to be drawn is that people’s innate need to protect their emotional well-being impacts their desire for wealth-maximizing portfolio decision making.

At first glance, investors have no problem distinguishing what constitutes a loss from a gain. These people know full well what they paid for the stock and they know the price they would receive if they sold it. But our desire to protect ourselves from emotional pain is great even when faced with an obvious loss. The solution relates to a concept known as a False Reference Point.

Assume investors buy a stock for $100 on January 2. Over the next six months, the price escalates to $150. By the end of the year, the price comes all the way back down to $110. Investors can view this erratic return behavior in one of two ways. First, they can calculate the return on the stock to be 10% [($110–$100)/ $100]. This reasonable rate of return will help them sleep at night. Second, they can move their reference point forward to the new higher level of $150 where they once could have sold the stock. In this case, they will feel like they lost 26.7% [($110–$150)/$150] in just six months. So which reference point do investors actually pick?

Poteshman and Serbin (2003) show that to their detriment, investors tend to select a stock’s 52-week high as the appropriate reference point. This is disadvantageous for several reasons. First, if we couple this high starting point with the concept of regret aversion, investors will be hesitant to sell stocks that have slipped from their 52-week highs because this will be tantamount to admitting they made a mistake. Granted, the overall investment could have made a positive return, but this higher, false reference point leaves investors with the feeling they lost money—at least on some level. Because investors view the stock purchase as a failure, they will be less likely to sell it even when their quantitative analysis indicates they should sell the stock (Shefrin and Statman, 1985).

So how do regret aversion and false reference points relate to real estate? Home prices escalated rapidly in the Hawaiian market in the late 1980s. Those who bought near the peak had to stomach a downward market for the next decade. In 2001, when the real estate market finally turned around, those who bought in 1989 were still looking at prices below what they paid. These investors were hesitant to sell. For investors who bought near the bottom in 2001, they were willing to sell as soon as one year later because they had already made a profit. But it wasn’t until only recently that buyers from the late 1980s began to sell because doing so sooner would have meant selling their home at a loss.

Rational financial theory would indicate that the two groups should be willing to sell based strictly on the prevailing price at the time, not based on the purchase price paid over a decade ago. Genesove and Mayer (2001) observed similar JRER Vol. 30 No. 4 – 2008 464 Seiler, Seiler, Traub, and Harrison behavior in the Boston market. They added that those who bought at the peak listed their homes for sale at 25% to 35% higher than fair market value in hopes of avoiding regret aversion. This behavior caused their homes to remain on the market much longer than sellers who purchased more recently and had more realistic asking prices. Rational behavior can also be deviated from when a person’s private information is confirmed by an independent, objective external market source. Wang, Zhoa, Chan, and Chau (2000) demonstrate that developers become over-confident and that their over-confidence leads to over-building. These actions are found to cause excessive volatility in the real estate sector and even affect real estate cycles.

While the concept of regret aversion is relatively new to the real estate literature, a number of recent studies do provide evidence that prior expectations of market participants may well alter behavior in potentially sub-optimal manners (i.e., false reference points may be relatively common). For example, Ooi, Webb, and Zhou (2007) provide evidence of underpricing in the market for value REITs, consistent with extrapolation theory. They posit the observed mispricing is due to ‘‘investors over extrapolating past corporate results into the future.’’ These behavioral tendencies of investors to rely upon the potentially flawed metric of past corporate performance as an anchor to assess future performance is consistent with the anchoring biases discussed above. Similarly, Peiser and Xiong (2003) argue ‘‘the perception of high crime rates in downtowns has hindered the revitalization of downtown shopping districts and adjacent residential areas.’’ Interestingly, they go on to demonstrate that crime rates are actually higher in suburban areas of San Diego and Los Angeles than in their downtown areas, thus the erroneous assumption of higher crime in inner cities may lead to a misallocation of investment dollars. Continuing, traumatic events may also serve as false reference points that serve to temporarily bias valuations in a predictable manner. For example, Bleich (2003) demonstrates that capitalization rates increased dramatically in the Los Angeles, California apartment market following the Northridge earthquake of 1994. This event temporarily shifted market perceptions (i.e., created a false reference point/anchor) of the inherent risk level of these residential units, thus significantly depressing prices. However, within three years market risk perceptions eased, and cap rates (and prices) returned to their previous levels. Finally, while not directly attributable to the regret aversion and false reference point paradigms, which serve as the foundation of the current investigation, two additional studies provide further, related evidence that psychological factors may very well influence decision making in real estate markets. Specifically, Haag, Rutherford, and Thomson (2000) find that realtor comments influence transaction prices by altering perceptions of the subject property’s quality, while Evans and Kolbe (2005) demonstrate that home sellers may actually benefit from familiarity biases that induce them to use previous listing agents as the selling agents for their properties. Taken together, these results demonstrate the expanding application of behavioral finance concepts to real estate market activities and transactions.

Regret Aversion and False Reference Points 465 Theory In regret theory, people are assumed to ‘‘remember their previous experiences and form expectations about the rejoicing and regret that the present alternatives might entail,’’ (Loomes and Sugden, 1983, p. 428). The basic model is as follows: there are S {S1, S2,..., Sn} states of the world, where each Sk occurs with probability pk and n 1 pk 1. An investment strategy is represented by an n-tuple of state k contingent consequences Ai (wi1,..., wik,..., win). wik W denotes the monetary consequence in terms of the investor’s final wealth position of investment strategy Ai in the state of the world Sk. For any investor, there exists a twice differentiable and concave utility function that maps the set of monetary consequences into the set of real numbers, U W → R. Loomes and Sugden referred to it as ‘‘choiceless utility function,’’ that is, U(wik) represents the anticipated utility of having to experience the monetary consequence wik as if it were imposed exogenously (and not due to an active choice).

Suppose that the investor has to choose between two alternative investment strategies, Ai and Aj. If he chooses Ai and the state of the world Sk occurs, he will experience wik but at the same time pass up wjk. Hence, in addition to U(wik), he will feel rejoice if wik wjk and he will feel regret if wik wjk. Regret and rejoice are also anticipated by the investor. They are represented by the regret function, g( ), which is strictly increasing and g(0) 0. The modified utility of choosing Ai instead of Aj, given that the state of the world Sk occurs, incorporates anticipated

utility and anticipated regret:

–  –  –

In regret theory, the decision maker is assumed to minimize anticipated regret by n maximizing Ei k 1 pkV(wik, wjk), that is, the expected utility of (1).

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