Oct012008

Bubble Market Psychology – Part 1

Bubble Market Psychology

Financial markets are driven by fear and greed: two basic human emotions. Rationality and careful analysis are not responsible for, or predictive of, current or future price levels in markets exhibiting bubble pricing as the emotions of buyers and sellers takes over. [1] The psychology of speculation drives bubble markets, and because of the nature of fear and greed, most speculators are doomed to lose their money. In contrast, true investors are not subject to the emotional cycles of the speculator, and they are more able to make rational decisions based on fundamental valuations. Of course, many investors also miss the excitement of a runaway price rally in a speculative bubble. The Great Housing Bubble was inflated by people trading houses. Residential real estate took on the character of a commodity, and it became subject to the same chaotic price gyrations as a speculative commodities market. This behavior was caused by lenders who provided the financing terms which enabled speculators to use mortgages as option contracts with the risk of loss being transferred to the lenders.

With any loss, an individual must go through a grieving process. Since markets are the collective actions of these individuals, markets experience the same psychological stages which are apparent in the price action. Efficient markets theory attempts to explain market price action through the collective action of rational market participants. This theory fails to explain the irrational behavior exhibited in bubble markets. Behavioral finance theory seeks to explain irrational exuberance. The price action in a bubble has other impacts on the beliefs and behaviors of individuals and society as a whole. These beliefs and behaviors may become pathological in nature leading to suffering and social problems. As with any form of mass hardship, there are calls for government action which lead to proposals for bailouts and false hopes among the populace.

Speculation or Investment?

Owner-occupied residential real estate is viewed by many people as a good investment. [ii] Realtors often use this idea as part of their sales pitch. As mentioned previously, this view is fallacious and it is one of the beliefs responsible for creating an asset price bubble. To understand why houses are not a great investment in most circumstances, one needs to understand the difference between investment and speculation.

An investment is an asset purchased to obtain a predictable and consistent cashflow. This would include things such as bonds and rental properties or even cash in a savings account. The value of the asset is based on the cashflow, and this value can be determined in a number of ways. For a “point in time” analysis simple division will yield the rate of return (return = income / investment). Risk is evaluated by comparing the rate of return of the investment to the safe return one can obtain in a savings account or government bonds. For more complex financial structures the value can be determined by a process known as discounted cashflow analysis. The sales price at the time of disposition is often not a major factor in the investment decision, particularly if the eventual disposition is many years in the future. In fact, true investments need never be sold to be profitable. As Warren Buffet noted, “I buy on the assumption that they could close the market the next day and not reopen it for five years.” [iii] In contrast to investment, speculation is the purchase of an asset to sell at a later date at a higher price (Actually, you can also speculate by selling first and buying later in a process known as “selling short”). Speculative assets are not valued based on cashflow but instead are valued based on the perceived probability of selling later for a profit. Houses can be purchased as an investment at the right price, but most often when people purchase a property they are engaging in speculation based on the belief they will be able to sell the house for a profit at a later date.

Since 1890 houses have appreciated at 0.7% over the general rate of inflation. Over the long term house values are tied to incomes because most people buy houses with mortgages for which they must qualify based on their income. Inflation keeps pace with wage growth because people will bid up the prices of goods and services with their available income. Therefore, over the long term house prices, wages and inflation all move in concert. There are short-term fluctuations in this relationship due to variations in financing terms, migration patterns, employment, local limits on construction and irrational exuberance, but any such deviations from the mean will be corrected over time by market forces. As an investment, houses serve as a hedge against the corrosive effect of inflation, but over the long term appreciation much in excess of the general rate of inflation is not possible. In this regard, houses are little better than savings accounts as an asset class, and they are inferior to stocks or bonds in the long term.

Leverage and Debt

As a speculative investment, residential real estate has the potential to make or lose vast sums of money due to the impact of financial leverage (debt). Houses are typically leveraged at 80% of their value. During the Great Housing Bubble, this leverage was often provided at 100% by various lenders. Leverage is a powerful ally when prices increase, but leverage works just as strongly against the speculator when prices decrease. For example, if a house is leveraged 80% and it increases in value 5% in one year, the return to the investor is actually 25% due to the 5 times multiplier created by leverage. With the effect of leverage, speculation on housing can far exceed any competing investment strategy. However, the inverse is also true. If a house is leveraged 80% and it decreases in value 5% in one year, the loss to the investor is 25% of her downpayment, not just the 5% the house declined in value. Leverage magnifies both the return and the risk of any speculative venture.

One of the worst mistakes lenders made during the Great Housing Bubble was to allow 100% financing and negative amortization loans. This was a boon for speculators because it allowed them to participate in the market without any of their own capital and it allowed them to hold the speculative assets with a minimal debt service expense. Plus, there was the implicit idea that they would simply default if the deal did not go in their favor (which of course many did). Combine these facts with the near elimination of loan underwriting standards allowing anyone to participate, and the conditions were perfect for rampant speculation, a wild increase in prices and so much speculative demand that many new and existing home purchases would remain vacant.

Why Speculators Fail

Despite the huge price spike in the final two years of the bubble caused by wild speculation, most speculators will lose a great deal of money. The causes are rooted in basic human emotions that work against making the proper decisions to profit in a speculative market. The moment a speculative asset is purchased and the speculator has taken a position in the market, emotions are immediately in play. If the potential resale price in the market is rising, the natural reaction is to want more. Greed takes over and the asset is strongly coveted by the speculator. If possible, the speculator will purchase more of the asset in question. This was common in the bubble when people would take the equity from one property and purchase even more residential real estate. The problem with this natural emotional reaction is that it prevents the speculator from selling the asset and taking profits when they are available. People who successfully make a living participating in speculative markets have learned to override this natural instinct and sell when their emotions are telling them to buy more. The average residential real estate speculator does not have this discipline or awareness. He will hold the asset through the good times.

When prices begin to fall in a speculative market, most speculators immediately lapse into denial. They were so emotionally rewarded by purchasing and holding the asset, they see no reason to believe the first signs of a declining market are anything other than a temporary aberration. As prices continue to fall, the emotions change: fear begins to creep in, and the battle between denial and fear goes on well past the breakeven point where the speculator could have closed the position without losing any money. [iv] As prices fall further, the fear begins to take an emotional toll and the speculator starts to feel pain. As prices drop further, more pain is inflicted on the speculator. What is the natural reaction to pain? Push it away. As a speculative investment becomes painful, the natural reaction is to want to get rid of it. This prompts the speculator to sell the asset–only after he has lost money. Speculator’s emotions always work against them. When the asset is rising in price they want more of it, and when it is falling in price they want less. This is a natural reaction, and it is a primary cause of losses in speculative markets. This is why most speculators fail.

Figure 31: Speculator Emotional Cycle

Speculator Emotional Cycle

 

Two Kinds of Real Estate Investors

There are two types of true real estate investors: Rent Savers and Cashflow Investors. These two groups will enter a real estate market without regard to future appreciation because either the cash savings or the positive cashflow warrant the purchase price of the asset. These people are largely immune to the emotional pratfalls of speculators because the value of the investment to them is not dependent upon a profit to be garnered when the asset is sold. They will hold the asset through any price declines because they are not feeling any pain when prices drop. Since these investors will purchase houses even if prices are declining, they are the ones who move in to create a bottom and end the cycle of declining prices.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and the result is an unending downward spiral. It takes Rent Savers and Cashflow Investors entering the market to provide support, break the cycle and create a bottom.

Rent Savers are buyers who enter the market when it is less expensive to own than to rent. It does not matter to these people what houses will trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them. Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.

Buyer Support Levels

When do Rent Savers and Cashflow Investors move in to a market and create a bottom? When comparative rents come into alignment with the total cost of ownership, Rent Savers enter the market and begin purchasing real estate. It makes sense for them to do so because ownership becomes a savings over renting (hence the term Rent Saver). The “return” on the investment is the hedge against inflation the Rent Saver obtains by locking in the cost of housing with a 30-year, fixed-rate, fully-amortized mortgage. As rents in the area continue to increase, these costs are not borne by the Rent Saver. Utilizing the price-to-rent concept, the Rent Savers will enter the market when this ratio falls to 154 (based on financing terms available in 2007). There will be some buyers who enter at higher prices, but there will not be enough of them to stabilize the market. It takes a decline in prices to where it is less expensive to own than to rent before enough new buyers enter the market to create a bottom. However, there are some properties that Rent Savers will not purchase because they really do not want to live in them. This includes transitory housing like apartments or small apartment-like condominiums. Prices on these properties will generally drop below the 154 price-to-rent breakeven for owner occupants until they reach price levels where Cashflow Investors will purchase them as rental properties. Since these investors do not want to merely break even, the price must be low enough for the rental rate to exceed the cost of ownership by enough to provide a return on the investor’s capital. Historically, price-to-rent ratios from 100-120 are required to create the conditions necessary to attract Cashflow Investors’ capital.

When it comes time to consider purchasing a house, each person should evaluate if their motivation is one of an investor or one of a speculator. Investment in real estate requires an accurate assessment of the revenue (or savings) and the costs associated with the property. If the cashflow from the property warrants the purchase of the investment–without regard to future asset value–then it is a true investment, and the risks of ownership are much reduced. If the property’s asset resale value were to decline, the investment value would still be there, and the investor would feel no pain and no pressure to sell. In contrast, speculation is a loser’s game, and if the motivation is to capture a windfall from future appreciation, there is a good chance it may not work out as planned because the emotions of a speculator will cause a sale at the worst possible time. A few can put their emotions aside and properly evaluate the market and trade the asset, but most who profit from speculation simply sell at the right time due to life’s circumstances. In short, they get lucky. The people who bought late in the rally and are holding on to the asset while they drift further and further underwater–they are not so lucky.

Trading Houses

During the Great Housing Bubble, many speculators tried to make money through trading houses. The vast majority of these traders were not professionals but amateurs who thought they could be professionals. Most amateurs ended up losing money because they did not understand what it takes to be successful in a speculative market. [v] The first and most obvious difference in the investment strategy between professional traders and the amateurs in the general public is their holding time. Traders buy with the intent to sell for a profit at a later date. Traders know why they are entering a trade, and they have a well thought out exit strategy. The general public adopts a “buy and hold” mentality where assets are accumulated with a supposed eye to the long term. Everyone wants to be the next Warren Buffet. In reality this buy-and-hold strategy is often a “buy and hope” strategy–a greed-induced, emotional purchase without proper analysis or any exit plan. Since they have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them to. In short, it is an investment method guaranteed to be a disaster.

There is evidence that houses were used as a speculative commodity during the Great Housing Bubble. Since the cost of ownership greatly exceeded the cashflow from the property if used as a rental, the property was not purchased for positive cashflow, and by definition, it was a speculative purchase. Confirming evidence for speculative activity comes from the unusual and significant increase in vacant houses in the residential real estate market.

If markets had not been gripped by speculative fervor, vacancy rates would not have risen so far above historic norms. If houses had been purchased for investment purposes to make money from rental income, the houses would have been occupied after purchase and vacancy rates would not have gone up. A rise in vacancy rates would have resulted in downward pressure on rents, and the investment opportunity–if it had existed initially (which it did not)–would have disappeared with the declining rent. There is only one reasonable explanation for increasing house prices and increasing rents during a period when house vacancy rates increased 64%: people were purchasing houses for speculative gains and leaving them unoccupied while the owners waited for prices to rise. [vi]

Figure 32: National Homeowner Vacancy Rate, 1986-2007

National Homeowner Vacancy Rate, 1986-2007

 

When house prices stopped their dizzying ascent, many speculators found themselves with large monthly debt service costs and no income to offset expenses. Many chose to quit paying their mortgage obligations and allowed the property to be auctioned at foreclosure. Many chose to rent the properties to reduce their monthly cashflow drain, and they became accidental landlords. In the vernacular of the time, they became floplords–flippers turned landlords.

Becoming a floplord was fraught with problems. First, they were not covering their monthly expenses, so the losses on the “investment” continued to mount. For houses purchased near the peak in 2006, rent only covered half the cost of ownership unless the speculator used an Option ARM with a very low teaser rate (which many did). Becoming a floplord was a convenient form of denial for losing speculators because they believed they were buying themselves time until prices rose again, allowing them to sell later either at breakeven or for a profit. Since they bought in a speculative mania, prices were not going to recover quickly and the denial soon evolved into fear, anger and finally acceptance of their fate. Another problem floplords faced was their own inexperience at managing rental properties. Most had never owned or managed a rental property, and none of them purchased the property with this contingency in mind. They often found poor tenants who did not reliably pay the rent or properly care for the property. This created even more financial distress and greater loss of property value as the property deteriorated through misuse.

The problems of renting were not confined to the floplords. Sometimes innocent renters were the ones who suffered. Many floplords collected large security deposits and monthly rent checks from tenants and yet failed to pay their mortgage obligations. This situation is called “rent skimming,” and it is illegal in most jurisdictions, but this crime is seldom prosecuted. Most of the time, the first indication a renter had that their rent was being skimmed was finding a foreclosure notice on their front door. By the time of notification, several months of rental payments were gone and the renters were evicted soon after the foreclosure. Renters seldom recovered their security deposits.

Houses as Commodities

Commodities are items of value and uniform quality produced in large quantities and sold in an open market. Although every residential real estate property is unique, these properties became uniformly desired by investors because all real estate prices rose during the Great Housing Bubble. The commoditization of real estate and the active, open-market trading it inspires caused houses to lose their identity as places to live and call home. Houses became tradable stucco boxes similar to baseball playing cards where buying and selling had nothing to do with possession and use and everything to do with making money in the transaction. [vii]

In a commodities or securities market, rallies unsupported by valuation measures fall back to fundamental values. It is very clear the rally in house prices was not caused by a rally in the fundamental valuation measures of rent or income. Many people forgot the primary purpose of a house is to provide shelter–something which can be obtained without ownership by renting. Ownership ceased to be about providing shelter and instead became a way to access one of the world’s largest and most highly leveraged commodity markets: residential real estate.

Commodities markets are notoriously volatile. In fact, this volatility is the primary draw of commodities trading. If market prices did not move significantly, traders would not be interested in the market, and liquidity would not be present. Without this liquidity, hedgers could not sell futures contracts and transfer their risk to other parties, and the whole market would cease to function. Commodities markets exist to transfer risk from a party that does not want it to a party who is willing to assume this risk for the potential to profit from it. The commodities exchange controls the volatility of the market through the regulation of leverage. It is the exchange that sets the amount of a particular commodity that is controlled by a futures contract. They can raise or lower the amount of leverage to create a degree of volatility attractive to traders. If they create too much leverage, the accounts of traders can be wiped out by small market price movements. If they create too little leverage, traders lose interest.

The same principles of leverage that govern commodities markets also work to influence the behavior of speculators in residential real estate markets. If leverage is very low (large downpayments or low CLTV limits,) then speculators have to use large amounts of their own money to capture what become relatively small price movements. If leverage is very high (small downpayments or high CLTV limits,) then speculators do not have to put up much money to capture what become relatively large price movements. The more leverage (debt) that can be applied to residential real estate, the greater the degree of speculative activity that market will see. Also, the smaller the amount of money required to speculate in a given market, the more people will be able to do so because more people will have the funds necessary to participate. When lenders began to offer 100% financing, it was an open invitation to rampant speculation. This makes the return on investment infinite because no investment is required by the speculator, and it eliminates all barriers to entry to the speculative market. In a regulated commodities market, the trader is responsible for all losses in the account. In a mortgage market dominated by non-recourse purchase money mortgages, lenders end up assuming liability for losses in the speculative residential real estate market.

Mortgages as Options

An option contract provides the contract holder the option to force the contract writer to either buy or sell a particular asset at a given price. A typical option contract has an expiration date, and if the contract holder does not exercise his contract rights by a given date, he loses his contractual right to do so. An option giving the holder the right to buy is a “call” option, and the option giving the holder the right to sell is a “put” option. Writers of option contracts typically obtain a price premium for taking on the risk that prices may move against their position and the contract holder may exercise his right. The holder of an options contract willingly pays this premium to limit his losses to the premium paid if the investment does not go as planned. Most options expire worthless.

Mortgages took on the characteristics of options contracts in the Great Housing Bubble. Speculators utilized 100% financing and Option ARMs with low teaser rates to minimize the acquisition and holding costs of a particular property. The small amount they were paying was the “call premium” they were providing the lender. If prices went up, the speculator got to keep all the gains from appreciation, and if prices went down, the speculator could simply walk away from the mortgage and only lose the cost of the payments made, particularly when this debt was a non-recourse, purchase-money mortgage. Another method speculators and homeowners alike used was the “put” option refinance. [viii] Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well. The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. In fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks. Of course, mortgages are not option contracts, and lenders did not view themselves as selling option premiums to profit from the premium payments; however, speculators certainly did view mortgages in this manner and treated them accordingly.

The “put” and “call” option features of mortgages during the bubble are the direct result of 100% financing. Speculators and homeowners have too little to lose to behave responsibly when 100% financing is available. Without increasing the cost to speculators through downpayments or a loan-to-value limit on refinances, speculators are going to utilize these mortgage products in ways they were not intended. There are many expensive lessons learned by lenders concerning 100% financing during the Great Housing Bubble.

The Stages of Grief

Markets are the collective actions of individuals, and the psychology of the markets can be broken down to the psychology of the individual participants who make it up. When price levels in a financial market collapse, most people lose money. Any loss has a psychological impact on the individual causing her to experience grief. The grieving process is generally divided into several overlapping stages: denial, anger, bargaining, and acceptance. These stages are also apparent in the mass psychology of the market.

When prices first drop, the individual market participants feel confusion and attempt to avoid the truth. They feel denial. This is motivated by fear (or truth) they may have been wrong to purchase when they did, and they might lose money. They seek ways to quell these fears. Rather than attempt to objectively review facts to ascertain whether or not the unexpected market behavior is the beginning of a new trend, most market participants will seek out data consistent with their original assessment. Denial is a natural reaction, but it is a very costly one when applied to a financial market.

When the initial price drops in the market begin to show the signs of a new trend, market participants become fearful. They work to maintain their denial, but there are moments when the awful truth cannot be contained. The little, fearful voice inside of each buyer gets louder and louder. This boils over into anger, frustration, and anxiety. The individual desperately is seeking ways to maintain denial, but reality becomes stronger than denial. She imagines the possibility that the reality she is trying to deny is the truth. This leads to depression and detachment as reality is too painful to accept. The sadness of the imagined loss is often suppressed or glossed over with a veneer of anger.

Finally, “as the going gets tough, the tough get going,” and the individual seeks ways to get out of the problem through emotional bargaining. This behavior often takes the form of a negotiation with Fate or the market. One amusing example of this behavior is the purchase of a St. Joseph statue. [ix] Burying this statue in the yard is supposed to secure God’s blessing and ensure a quick sale. Some will take more productive action. Perhaps it is lowering an asking price, or taking the property off the market and doing some renovations to “add value.” Some will not take action, and they lapse back into denial because the market is “coming back soon.” Those owners who chose to lower their price as part of their bargaining may get out with minimal losses (assuming they lower it enough to actually sell). Those that choose other courses of action, lose much more money.

In past market declines each individual reached acceptance of the market reality. Some chose to continue making payments on their “investment” and wait out the bear market. In the aftermath of the coastal bubble of the early 90s, many sellers accepted the market was a buyer’s market, and many sellers chose to keep making their payments and keep their properties. Those that chose to keep their property in the Great Housing Bubble did not have the ability to make these payments, and the property became a forced sale at a foreclosure auction. Some individuals reached acceptance and chose to sell their property on their own.

Efficient Markets Theory

Figure 33: Efficient Markets Theory

Efficient Markets Theory

 

The efficient markets theory is the idea that speculative asset prices always incorporate the best information about fundamental values and that prices change only because new information enters the market and investors act in an appropriate, rational manner with regards to this information. [x] This idea dominated academic fields in the early 1970s. Efficient markets theory is an elegant attempt to tether asset prices to fundamentals through the common-sense notion that people would not behave in irrational ways with their money in financial markets. This theory is encapsulated by the “value investment” paradigm prevalent in much of the investment community.

In an efficient market, prices are tethered to perceived fundamental valuations. If prices fall below the market’s perception of fundamental value, then buyers will enter the market and purchase the asset until prices reach their perceived value. If prices rise above the market’s perception of fundamental value, then sellers will enter the market to sell the asset at inflated prices. Efficient markets theory explains the majority of market behavior, but it has one major flaw which renders it inoperable as a forecasting tool: it does not explain those instances when prices become very volatile and detach from their fundamental valuations. This becomes painfully obvious when adherents to the theory postulate new metrics to justify fundamental valuations that later prove to be completely erroneous. [xi] The failed attempts to explain anomalies with the efficient markets theory lead to a new paradigm: behavioral finance theory.

Behavioral Finance Theory

Figure 34: Behavioral Finance Theory

Behavioral Finance Theory

 

Behavioral Finance abandoned the quest of the efficient markets theory to find a rational, mathematical model to explain fluctuations in asset prices. Instead, behavioral finance looked to psychology to explain asset valuation and why prices rise and fall. The primary representation of market behavior postulated by behavioral finance is the price-to-price feedback model: prices go up because prices have been going up, and prices go down because prices have been going down. If investors are making money because asset prices increase, other investors take note of the profits being made, and they want to capture those profits as well. They buy the asset, and prices continue to rise. The higher prices rise and the longer it goes on, the more attention is brought to the positive price changes and the more investors want to get involved. These investors are not buying because they think the asset is fairly valued, they are buying because the value is going up. They assume other rational investors must be bidding prices higher, and in their minds they “borrow” the collective expertise of the market. [xii] In reality, they are just following the herd. This herd-following has long been a valid investment technique employed by traders known as “momentum” investing. [xiii] It is not investing by any conventional definition because it relies completely on capturing speculative price changes. Success or failure often hinges on knowing when to sell. It is not a “buy and hold” strategy.

The efficient markets theory does explain the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon. There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations. During the Great Housing Bubble, the primary precipitating factor was the lowering of interest rates. The precipitating factor simply acts as a catalyst to get prices moving. Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the “smart money” must know something, and there is a widespread belief prices could not rise so much without a good reason. Herd mentality takes over.


[1] Social psychology is an important factor in the transmission of booms and speculative mania; however, the perception of this fact by market participants is not common. Most individuals attribute price increases to some fundamental factor whereas the actual price movements are driven mostly by mass psychology. (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988)

[ii] Karl Case and Robert Shiller noted (Case & Shiller, Is There a Bubble in the Housing Market, 2004) 90% or more of households expected house prices to increase in the following year during price rallies. It is the expectation of 10-year appreciation that is most striking. Market participants in the coastal bubble markets expected a 10-year average annual increase of near 15%. This would mean a tripling of prices over a 10-year period.

[iii] (Miles, 2004)

[iv] In the paper Investor Psychology and Security Market Under- and Overreactions (Daniel, Hirshleifer, & Subrahmanyam, 1998), the authors document that investors have two biases which negatively impact their financial decisions: first, they have an overreliance on private information and analysis with regards to asset prices, and they have a biased self-attribution or belief in themselves that causes them to be overconfident in their investment outcomes. In short, people go into denial because they are overconfident about the direction of the trade.

[v] The best books for understanding the mindset of a professional trader are the books by author Mark Douglas (Douglas, The Disciplined Trader, Developing Winning Attitudes, 1990) and (Douglas, Trading in the Zone, 2000). He lays out the emotional issues of trading in great detail.

[vi] (Mints, 2006) According to Victor Mints in his study of the Moscow housing market, the number of vacant houses held for sale by speculators showed the same pattern as the United States.

[vii] In their paper Prospect Theory: an Analysis of Decision under Risk (Kahneman & Tversky, Prospect Theory: An Analysis of Decision under Risk, 1979), the authors note a tendency of people to overweight low probability events which contributes to the attractiveness of insurance and gambling. Toward the end of the rally of the Great Housing Bubble when prices stopped rising, it became apparent that a resurgent rally was not very likely; however, many still bought in anticipation of this rally because 100% financing was available and they tended to overweight the probability of a rally.

[viii] In the paper Moral Hazard in Home Equity Conversion (Shiller & N.Weiss, Moral Hazard in Home Equity Conversion, 1998), Robert J. Shiller and Allan N.Weiss document the moral hazard issues in cash-out refinancing as follows “Home equity conversion as presently constituted or proposed usually does not deal well with the potential problem of moral hazard. Once homeowners know that the risk of poor market performance of their homes is borne by investors, they have an incentive to neglect to take steps to maintain the homes’ values. They may thus create serious future losses for the investors.” They miss the most serious problem resulting in lender losses, the predatory “put” exercised by borrowers. There are clearly moral hazards in cash-out refinancing; they are even more severe than the ones documented in this paper.

[ix] The author has a difficult time believing that a God would intervene in a financial market based on the purchase of an idol. It is not surprising a superstition like this one would spring up once houses started to be traded more frequently. There are myths about the practice going back hundreds of years, but references to the practice only go back to the early 1980s – a time corresponding to the slump after the first California real estate bubble. http://www.snopes.com/luck/stjoseph.asp

[x] Much of the history of the Efficient Markets theory is outlined in Robert Shiller’s paper (Shiller, From Efficient Market Theory to Behavioral Finance, 2002), “The efficient markets theory reached the height of its dominance in academic circles around the 1970s. Faith in this theory was eroded by a succession of discoveries of anomalies, many in the 1980s, and of evidence of excess volatility of returns. Finance literature in this decade and after suggests a more nuanced view of the value of the efficient markets theory, and, starting in the 1990s, a blossoming of research on behavioral finance. Some important developments in the 1990s and recently include feedback theories, models of the interaction of smart money with ordinary investors, and evidence on obstacles to smart money.” One of the groundbreaking papers of the early 1990s that influenced the change in economics thinking from efficient markets to behavioral finance was the work by David Porter and Vernon Smith (Porter & Smith, 1992) on Price Expectations in Experimental Asset Markets with Futures Contracting. In this paper, the authors demonstrated the volatility of returns was excessive as prices detached greatly from fundamental values and stayed detached for extended periods of time.

[xi] In the paper Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias (Kahneman, Knetsch, & Thaler, The Endowment Effect, Loss Aversion, and Status Quo Bias, 1991), the authors, Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler, begin to lay the foundations for behavioral finance theory by documenting the many anomalies the efficient markets theory could not explain, “Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if’ it is difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm.”

[xii] In the paper Learning from the Behavior of Others: Conformity, Fads, and Informational Cascades (Bikhchandani, Hirshleifer, & Welch, 1998), the authors, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, describe the phenomenon of herd behavior and observational learning. Much of human learning is accomplished through observation and imitation of others. This valuable survival skill results in the herd behavior observed in financial markets. It is the driving force behind the price-to-price feedback loop responsible for irrational exuberance.

[xiii] In House Prices, Fundamentals and Bubbles (Black, Fraser, & Hoesli, 2006), the behavior of momentum investors is characterized as evidence against rationality in the marketplace. For the typical amateur speculator this is certainly true, but for momentum traders who have learned how to buy and sell to profit from the momentum, it is a rational and profitable method of speculation.