Housing Prices and Behavioral Economics

In traditional finance text books, assets are always priced perfectly by the cool, rational work of markets. In the real world, human behavior has a huge influence on what things sell for, particularly houses. That’s lead to an area of research called behavioral economics—the study of how people’s emotions impact their financial decisions.

A couple of weeks ago I put in an offer on a three-bedroom, bank-owned home in Pomona, California, which is about a half hour east of Los Angeles. The house was listed at $144,500. I offered $145,000. My offer was accepted this week. I was told there were two offers above mine, including one at $180,000. How did I win? I offered to pay cash. The bank that owned the property saw less of a risk of my sale not going through. Was this rational thinking on the bank’s part? Or are they making pricing mistakes just to clear out inventory as quickly as they can?

Now let’s look at the other bidders. There were sixteen offers in all. That means thirteen offers were below mine. I offered just $500 above the asking price. This is a house that sold in 2006—I kid you not—for $400,000. Why, given that 66% discount, were more people not willing to go above the asking price? Behavioral economics. Everyone wants a deal.

Lastly, let’s take a look at my thinking. A week ago I would have been happy as a clam my offer was accepted. Every bit of analysis I did showed this was just a screaming deal. But on Monday I learned that our parent company, McGraw-Hill, might sell BusinessWeek. Suddenly my future job prospects looked less certain. From an investment standpoint this purchase made perfect sense, from an emotional one? I withdrew my offer. Time will tell if I was prudent or just chicken. You can be both, I believe.

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