There has been a run of fascinating research into fear and the psychology of investing, some of it Nobel-prize winning, and much of it highly relevant to the current property investment market in Australia.

 

In summarised form, what two Nobel-prize winning researchers (Daniel Kahneman and Amos Tversky) found was that......

 

1.       People tend to think and act in terms of gains and losses, rather than in terms of their wealth position, and

 

2.       Financial losses loom much larger for people than do financial gains.

 

Because of these two factors, people tend to be far more risk-averse than they actually need be, especially if looked at in term of their own rational self-interest over the longer-term.

 

In fact, the short-term/long-term distinction turns out to be critical.

 

In a 2002 interview in Forbes magazine, one of the Nobel researchers (Kahneman) pointed out that when you think in terms of wealth you are thinking long-term, and that when you think in terms of wealth you tend to be much less risk-averse.

 

Other research published in mid-2005 and cited by Forbes compared the investing performance of 'normal' participants and those with lesions to that part of the brain that controls emotions. In a simulated investment exercise the brain-damaged players made better investment decisions, meaning that they invested more often (where the odds favoured investments generating a net gain). The implication is that emotion interferes with investment decisions.

 

Put that together with the Kahneman and Tversky findings and what you get is that the fear of short-term loss weighs so heavily on people that they invest less than they would if they were following their own rational long-term self-interest.

 

This situation is highly pertinent to property investors in Australia.

 

House prices in some cities (especially Sydney) have declined in recent periods (a short-term loss) while the same markets have nonetheless made impressive gains when viewed over a longer horizon (long-run wealth gains).

 

Every press report of property prices that shows a decline in prices - especially in the larger capital cities or the national averages which reflect them - fuels peoples' acute fear of loss, reinforcing their sense that they shouldn't invest in property.

 

House price movements across all Australian capital cities over the past 10 years have averaged annual growth of 8.6 percent. Add to this a crude (but conservative) estimate of average rental yield of 4 percent and you get a total gross return of 12.6 percent per annum.

 

 

 

 

The graph above shows the figures measured at June each year, itemised into capital growth plus the estimated 4 percent per year rental component.

 

Despite this solid performance, and with no reason to doubt its continuation, investors have abandoned property in droves. In October 2003 investor housing finance commitments for the month totalled $7.4 billion; two years later this figure decreased by $1.8 billion to $5.6 billion.

 

The scenario where investors have abandoned an average 12.6 percent annual return from property because of short-run capital losses mirrors the investment gains missed by the 'normal' research participants in avoiding short-run losses. How rationally self-interested is it to forgo a 12.6 per cent per annum return over the long run to avoid a minor short-run capital decline?

 

Of course, no-one knows ahead of time that the average annual return on a property investment will be 12.6 percent. But there's a convincing argument that property's solid performance over the long-run parallels the odds-on net gains generated by the investment in the experiment with brain-damaged players.

 

Someone who is arguably more qualified to comment on investment risk and return (although not remotely inclined towards academic research) is Donald Trump. Trump provides another - but different - twist on the impact of fear on wealth. As he observed in his book The Art of the Deal:

 

I like thinking big.....Most people think small, because most people are afraid of success, afraid of making decisions, afraid of winning. And that gives people like me a great advantage. (Warner Books 1987)

So not only are people more afraid of loss than they are attracted to gain, but they can be afraid of gains as well!

 

What can you do to deal with fear?

 

Here are some tips.... 

  • distinguish your fear when it is activated. Fear mostly operates in the background at an unconscious level. Our consciousness of fear - whether of loss or of success - is fleeting at best, but it is necessary to recognise fear in order to not be held hostage by it.
  • having distinguished your fear, choose whether you will be stopped by it. You are not likely to eliminate your fear, at least not in the short-run (many fears are rooted in biological needs for self-preservation). But you may choose not to be stopped by it when it is activated, and you are thinking big and pursuing your chosen course of wealth-creation.
  • take a long-term wealth-oriented view rather than a short-term gain or loss perspective. A long-term investment horizon puts any short-term losses into perspective, and absorbs the effects of cyclical ups and downs. It therefore allows you to be less risk-averse, enabling you to invest more and create greater wealth.
  • get in the habit of thinking big. Entertaining big thoughts may well activate your fear of success, but this will provide opportunities for you to distinguish that fear, and place it in the context of the exciting possibilities which you are pursuing.
  • ground your judgement in objective analysis and your actions in rational courage. Do the math. Identify various risks (market risk, interest rate risk, income risk etc.) and weigh them up relative to sensible estimates of returns. Trump counsels to 'protect the downside, and the upside will take care of itself.' Make safe bets. If it all stacks up, take the plunge and don't look back.

Armed with this understanding, and by following these steps you'll be in a much stronger position to deal with your fear and to short-circuit its wealth-limiting power. Since other people's fears provide opportunities for you, you'll be poised to strike at attractive opportunities which were hitherto off the radar.

 

Do that, and you'll be profiting from the same sort of advantage enjoyed by Trump.

 

 

    







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