Beware of the ‘fallacy of composition’

[Scallywag1]

I do not want to offend anyone by this post. I understand that taking the decision to invest significant amounts of money in an asset like residential property often requires a lot of hard work and fortitude. I am merely trying to offer what I think may be some constructive comments.

In simple terms, in economics, the fallacy of composition refers to the logical mistake of assuming that what applies to the individual will also apply to the group. For example if you are at a football game and you stand up to get a better view, and if most people at the game do not follow your example, you will get a better view. However, if everyone at the game stands up to get a better view very few people will get a better view.

So what has this got to do with property investing? A lot I think.

I have read a number of posts on this forum where people have said that if the property market takes a modest turn for the worse they can always sell one or perhaps two of their investment properties to allow them to get through any downturn. It is true that if only a relatively small number of property investors sell one or two of their properties they will probably be able to sell them at a relatively small discount from the current market price (if not at a higher price). However, if a lot of property investors do the same thing it is likely that the supply of properties for sale will increase dramatically and the price they receive for these properties will likely fall dramatically; thus, the fallacy.

In summary, I just want to caution property investors on this forum from thinking that if they do have to sell one or more of their properties it will probably be, at worst, only a small discount from the current price. There is a significant risk that if a lot of property investors decide to sell one or more of their investment properties at the same time the price they receive for these properties may be significantly lower than they expected.

What do you guys think?

 

[Andrew_A]

Scallywag that's an interesting bias, thanks for sharing.

Can you link to a post where somebody on this forum mentioned selling one or two properties if they needed in a downturn as a risk management idea? I read a lot of the posts here and can't remember reading such a comment, could be my memory though.

 

[Pablo]

Scallywag,

What you described is often referred to as the herd mentality and many smart investors have made allot of money by going the opposite way, this is why I choose not to invest in shares middle of last year because everyone and their dog were jumping on board, now that shares are not so popular I am considering getting in.

Yes you are right if more people sell this will increase supply and could cause values to stagnate, or even drop, its simple supply and demand. I for one am not worried and plan to hold my properties indefinitely so have little problems if values go down in the short term (which I actually don't think will happen as I don't see a mass selling explosion happening yet).

You wouldn't happen to be another one of those guys from the global house crash forum would you?

Cheers,
Pablo.

 

[plusnq]

Hi Scallywag

The error in this theory is in its real world vs academic application. In research we make assumptions to allow us to create models that explain outcomes. The assumptions are critical and often explain why modelling does not accurately reflect real world results.

A simple exception in the example you provided is the assumption that everybody will rush for the exits at the same time. This behaviour may work for a fire but is unlikely in investments that have large commissions and expenses. There are some obvious questions that need to asked;

1. How many people have investment property?
2. What is the proportion of investment property to owner occupied? How much effect will this have on the general market? Hint: will owner occupiers sell or try and sit any downturn out? Therefore, why are some investors selling? Are reported prices only those who are selling because they are overstretched and/or poor market timing? Witness the variance between the struggling areas of Western Sydney and other areas.
3. What amount of loss needs to be incurred by an investor before they will consider selling ? For most investors this is a timing issue...when did they buy and how much capital gain do they have in the property? This will affect when they may choose to sell or if at all.
4. What are the yields and are they rising? This may influence investors to hang on rather than sell
5. The property market is a much slower market than others such as equities. With equities the price is marked to market and entry/exit costs are minimal compared to property. I can also sell a portion of my shares rather than being forced to sell all or nothing. This makes shares more volatile and exhibit greater herd characteristics especially on the downside. This is due, in part,to margin loans being marked to market.

Some thoughts to consider when considering analysing property. There is a lot more to consider than basic economic modelling theory of behaviour.

Cheers

Shane

 

[wylie]

I am probably the one who wrote about selling a property if I had to, in order to keep our heads above water.

I have told myself this for 30 years since I bought my first IP and have never had to do it. We have sold properties for reasons of lifestyle, to renovate our PPOR for example. I wish we hadn't sold, but in reality, we needed to renovate, so we took the profit and ploughed it into our own house. At lease we don't pay any capital gains tax when we sell our PPOR, so I am happy with the decision.

For me, selling a house to get us out of trouble is the last thing we would do. I would sell our car before selling a house, or I would find a job to tide us over.

I also take on board that if there is a recession or something, many people will be selling. But we have made a big gain on what we hold, so even a 50% drop in today's price would see us having made a big profit, so as a worst case scenario, selling even at half of today's value would get us out of trouble.

In reality though, we would do all we could to hold onto what we have.

For me, it is really just "self talk" to prove to myself that we will be okay. Quite flippant really.... "we can sell a house if we get in trouble" when in reality, it is not a decision we would make flippantly at all.

 

[boomtown]

Well said Wylie.

And I suggest there are a lot of people out there that think that way too (but they dont necessarily feel that way about their BHPB shares).

Can anyone tell me when was the last time an Australian capital city had a 20% drop in housing prices across the board (ie not just outer suburbs and not some dying regional town). I suspect the answer is never.

 

[HiredGoon]

Well said Wylie.
Can anyone tell me when was the last time an Australian capital city had a 20% drop in housing prices across the board (ie not just outer suburbs and not some dying regional town). I suspect the answer is never.

 

[s_t]

lol, thanks for the great laugh HG!!!




(not that I support your view!)

 

[boomtown]

Haha great cartoon.

 

[keithj]

Yep, great cartoon.... but it's in the wrong thread... HG should have put it into the 'What's the funniest/worst excuse you've heard for NOT investing from people?' thread.

 

[Andrew_A]

Yep, great cartoon.... but it's in the wrong thread... HG should have put it into the 'What's the funniest/worst excuse you've heard for NOT investing from people?' thread.

Yes it's a cracker of an excuse. You can never accurately measure tail risk situations, say 1 in a long period threats that will make your investing decision look silly or foolish.

Taleb uses the turkey example in 'Fooled by Randomness'

Just because an event has never happened yet doesn't mean it's not on the way. Taleb proposed the barbell strategy to counter this of having 90% of your investments in T Bills and 10% of your capital seeking some sort of VC like payoff, he doesn't give any time to the scenario where your 10% vanished however. A strategy that is so breath takingly lame I'm still wondering how he came up with it, in other moments he has mentioned the wisdom of an indexing approach... which strangely enough is what a lot of decent resi investing is with property imo.

I personally think there is an assymetry in risk/reward in our society, even though we might underweight potential serious risk events the payoff from these just isn't that scary, pick yourself up, go on and still get rich. Possibly not the best example and a bit extreme is our friend Bondy.. In past times he would have been burnt for what he did, now it's caviar and boats again.

 

[keithj]

Yes it's a cracker of an excuse. You can never accurately measure tail risk situations, say 1 in a long period threats that will make your investing decision look silly or foolish.

Taleb uses the turkey example in 'Fooled by Randomness'

IMO, diversification is the easiest way of avoiding the risk of these 1 in 100yr events.

Some smart PhD in China will work out how to easily split water into H & O and the oil industry will crumble, our CO2 problem will disappear & our disposable income will skyrocket (& so will house prices). Sure... it's a 1 in 100yr event... but mitigating against that risk is easy - diversify. That risk won't stop me from investing in oil stocks & turkey cartoons won't stop me from investing in property . But if either of those 1 in 100yr risks DO eventuate, I expect to survive.

I personally think there is an assymetry in risk/reward in our society, even though we might underweight potential serious risk events the payoff from these just isn't that scary, pick yourself up, go on and still get rich.

Yes... taking big risks is easy if you're starting from $0 - the downside is back to $0. But when the starting point is significant $$$, then the downside could still be back to $0.

 

[Rockstar]

Some smart PhD in China will work out how to easily split water into H & O and the oil industry will crumble, our CO2 problem will disappear & our disposable income will skyrocket (& so will house prices).

You think this hasn't been done yet! It's illegal of course to run your vehicle on Water (Hydrogen). Can't let the petrol industry crumble.

 

[joeExpat]

Can you link to a post where somebody on this forum mentioned selling one or two properties if they needed in a downturn as a risk management idea? I read a lot of the posts here and can't remember reading such a comment, could be my memory though.

http://www.somersoft.com/forums/showthread.php?p=395132#post395132
I've sold one already, didn't want to be caught in the scenario described, everyone heading for the exit at the same time.

 

[GoAnna!]

I spoke to some prospective buyers today and they are very frustrated with the buyers market. They say that all they can find is really expensive rubbish. They say there is very little to chose from and they are finding it quite frustrating. I wonder if some of the downturns in median prices will refect as much on the quality of the product as a softneing market.

 

[JAL]

N Z Experience

The current New Zealand experience is that even without a rush to the exits selling down is becoming very hard.
Monthly sales volumes are around half of last years numbers country wide. Prices are holding up much better than volumes to date.

I know of investors with properties on the market at under registered valuation and in some cases under purchase price who have had no offers in over six months on the market.

There are many reasons for the slow down in sales, but the effect is the same. Getting the money in your hand is not a quick or even sure process.

Some here (NZ) who may need to sell could find they have already missed the boat if the market weakens further.

I think the market is made at the margin, and those who have to sell set the tone. In our market that could be the new highly leveraged investors and new home owners who have paid up to eight times yearly income for a home.

 

[Andrew_A]

http://www.somersoft.com/forums/showthread.php?p=395132#post395132
I've sold one already, didn't want to be caught in the scenario described, everyone heading for the exit at the same time.

Joe, me too. Late 07 as you want to be selling when people are offering more than list price, if you want to be selling at all!

Scallywag hasn't answered the question I raised.

Look if you are worried about such a scenario, don't consult your favourite gold bug site or US based housing tale, talk to investors from the Gold Coast circa late 80's who had to sell after buying stuff OTP, people stuck with two tiered stuff and most everything in the 90's. That will give you a much better baseline for some scenario calculation imo.

 

[yieldmatters]

Yes it's a cracker of an excuse. You can never accurately measure tail risk situations, say 1 in a long period threats that will make your investing decision look silly or foolish.

Taleb uses the turkey example in 'Fooled by Randomness'

Just because an event has never happened yet doesn't mean it's not on the way. Taleb proposed the barbell strategy to counter this of having 90% of your investments in T Bills and 10% of your capital seeking some sort of VC like payoff, he doesn't give any time to the scenario where your 10% vanished however. A strategy that is so breath takingly lame I'm still wondering how he came up with it, in other moments he has mentioned the wisdom of an indexing approach... which strangely enough is what a lot of decent resi investing is with property imo.

To be honest I don't think you properly understand Taleb - you should probably give it a second read.

The turkey example is not about tail risk - it simply highlights that the past is not a good indicator of the future. Take a forecast of oil price (based on 20 years of historical trend data) prepared in 2001 for 2008. It will be so far off the mark it is ridiculous. It's not even in the tail! Well, technically in a normal distribution everything is in the tail as it never hits 0 but you know what I mean - it would be a 1 in 1,000,000,000,000 event.

The connection Taleb is making is this: if time series data is useless, then the variation around the mean is also useless, and therefore our assessment of the probability of a tail event is also useless. The losses the investment banks just took were not even in the tail of the risk managers working at these firms - they were mathematically near "impossible" according to their historical distributions of events around the mean.

So the point is people who get comfort from 30 years of property history could lose their head! People need to be more critical and think it through.

edit: there is the possiblity that I am the one who doesn't fully understand Taleb - people take out of it what they want to take out of it I guess.

 

[Sunder]

I spoke to some prospective buyers today and they are very frustrated with the buyers market. They say that all they can find is really expensive rubbish. They say there is very little to chose from and they are finding it quite frustrating. I wonder if some of the downturns in median prices will refect as much on the quality of the product as a softneing market.

Anna,

I agree with you on this one. Went to inspect a property this morning that was described as "seen better days" - and I agree, possibly 30 years ago.

What I'm noticing is that a lot of the properties I am seeing are currently rented out. So I suspect it's a lot of investors heading for the exit, either because they fear an impending crash, or not keeping up with payments.

First the downturn in median prices will reflect the low value PI properties, then depending on the impact of the US recession in Australia, it could be the higher quality OO properties coming on. We may see a lot of spikes and dips in the median house price over the next couple years.

 

[Andrew_A]

YM, if that's another thing I don't understand I will gladly add it to a long list.

I have read Fooled twice from cover to cover, done some brief reviews for my blog and refer back to it periodically for my own personal humiliation, I have read Black Swan once (tedious book), all of the material from Taleb I can source on the net and magazines (He's in quite a few trading mags) including his blog and web page and recorded lectures of which there are many, interviews and so on. Also I have researched Taleb's own trading record and some very interesting opinions from people smarter than me about his own performance with 'Empirica'. So it's not a question of effort on my part but rather a question of comprehension.

What exactly is tail risk for a thanksgiving turkey I wonder?

Everything is in the tail as you mention.

To be honest I don't think you properly understand Taleb - you should probably give it a second read.

The turkey example is not about tail risk - it simply highlights that the past is not a good indicator of the future. Take a forecast of oil price (based on 20 years of historical trend data) prepared in 2001 for 2008. It will be so far off the mark it is ridiculous. It's not even in the tail! Well, technically in a normal distribution everything is in the tail as it never hits 0 but you know what I mean - it would be a 1 in 1,000,000,000,000 event.

The connection Taleb is making is this: if time series data is useless, then the variation around the mean is also useless, and therefore our assessment of the probability of a tail event is also useless. The losses the investment banks just took were not even in the tail of the risk managers working at these firms - they were mathematically near "impossible" according to their historical distributions of events around the mean.

So the point is people who get comfort from 30 years of property history could lose their head! People need to be more critical and think it through.

edit: there is the possiblity that I am the one who doesn't fully understand Taleb - people take out of it what they want to take out of it I guess.