Analysis and behaviour

Citation

French, N. (2010), "Analysis and behaviour", Journal of Property Investment & Finance, Vol. 28 No. 3. https://doi.org/10.1108/jpif.2010.11228caa.001

Analysis and behaviour

Article Type: Editorial From: Journal of Property Investment & Finance, Volume 28, Issue 3

Real estate investment at a crossroads

Earlier this week in class, when I was discussing the role of herd behaviour in investment decision-making, one of my students asked the pertinent question of why do we do all this research and analysis if markets are ultimately driven by decisions made outside the parameters set by normative modelling? It is a very good question and one, for which, I do not necessarily have an answer.

Property investment is market driven. Markets are driven by confidence and sentiment. Many commentators argue that the current recession or downturn was the result of herd behaviour. That investors moved away from understanding and analysing the fundamentals of an investment (cash flow, growth, risk and return) and instead “followed the market” on the basis that the market could not be wrong and, indeed, on the back of some spectacular short term gains which, ironically, were being driven by the weight of money coming into the market and fuelling the (self fulfilling) prophecy of good returns. Unfortunately, returns without foundation often disappear as quickly as they arrived.

In 2008, I wrote a short article in the Estates Gazette in the UK proffering, as many before me, that property cycles are the inevitable consequence of behaviour (French, 2008). Whilst not belying the seminal works of Marx, Keynes, Smith, Friedman or any of the great economists with many more insights than the following simile can hope to convey, I have always felt that markets owe more to behaviour than rationality. My analogy, and one that is shared coincidentally and independently by other colleagues, is that markets react as the coyote in Warner Brothers’ “Road Runner” cartoon. In each episode, the coyote would chase the road runner to the edge of a cliff; at the last opportunity the road runner would make a miraculous turn and avoid the drop leaving the hapless coyote to run over the cliff edge, tread air, look down and then plummet. That is how property markets work! The cliff edge represents the solid foundations of good investment. The running over the cliff represents the momentum that markets assume and the treading air represents the over confidence of the players in the market in believing that things are still OK. It is only when there is a shock realisation of their situation (by looking down) that the market players react and the market panics and falls dramatically.

So why do not we see this coming? Why do not we spot the edge of the cliff and stop the crash? Surely, good research and modelling can do this? The problem lies with the models that we generally use in investment. The decision theory literature contrasts two types of decision models, descriptive and normative. The principal distinction is that normative models concentrate on “how decisions should be made”, whereas descriptive models look at “how decisions are actually made”. There is a strong body of evidence that the predicted rational models (normative) are rarely observable in practice (descriptive). What people “should do” in theory is often very different from the final decision.

If this is the case, then why, as my student asks, rely upon normative models? Is it that normative models are always erroneous, or do they just fail to encompass the behaviour of the decision maker? This is discussed at length, in relation to property investment, in a previous article by French (2001) but, in short, it argues that to dismiss a decision-making tool in its entirety because of its reliance on rational decision-making itself misses the bigger picture. These models are used; these models do influence decisions but they do not capture all the influences on the final decision. Normative models allow one to explore the implications of certain norms or ideals of behaviour. If we were to refine the model to apply normative ideas within the context of the findings of previous descriptive decision studies it may be possible to develop a better model, a prescriptive model, which provides the decision-makers with understanding and insights to inform their decision-making.

So does that viewpoint answer the question? If we were to develop such a model would it provide us with an early warning system or a “traffic light” system to help with property investment decisions? I have always believed that research is the cornerstone of good decision-making. I understand that normative models do not necessarily give the right answer but they are a signpost. With modification and greater insights, it is possible that a more definitive model could be developed. Maybe that is our new holy grail and maybe, if you believe the traditions and lore in that regard, then it is the seeking that gives credence to the goal. I do not know. As an academic, I obviously believe that good research does inform the decision maker but that does not mean that the decision maker will listen.

To add another analogy to this exposition, and bring the matter full circle, I once suggested that cash flow scenario testing (a form of normative modelling) offered a developer a flickering torch when traversing a metaphorical minefield in the dark. You would not see everything but it gave you a chance. The leading developer, to whom I was offering this advice, just looked at me and said “if I am in a minefield, I would prefer not to know”.

Nick FrenchOxford Brookes University, Oxford, UK