Academic journal article The Journal of Real Estate Research

Regret Aversion and False Reference Points in Residential Real Estate

Academic journal article The Journal of Real Estate Research

Regret Aversion and False Reference Points in Residential Real Estate

Article excerpt

Abstract

This study empirically exams the combination of regret aversion and false reference points in a residential real estate context. Survey respondents were put in a hypothetical situation, where they had purchased an investment property several years ago. Hindsight knowledge about a foregone all time high was introduced. As hypothesized, respondents on average expressed higher regret if they had actively failed to sell at the all time high (commission scenario) than if they had simply been unaware of the potential gain (omission scenario). Women were found to be more susceptible to regret aversion and false reference points than men.

Traditional financial theory approaches decision making from a very mathematical and logical standpoint. The reality, however, is that people make financial decisions. So no matter how quantitative and objective financial models are constructed, people must ultimately make buy and sell decisions. This melding together of mathematics and psychology is known as behavioral finance.

The few studies that use behavioral concepts in real estate have centered primarily on anchoring bias. Anchoring is the notion that people tend not to deviate from a given starting point even if new information dictates they should. For example, Northcraft and Neale (1987) found that once a starting price is given, even real estate professionals suffer from anchoring bias when valuing a home. This bias persists both when the anchor is generated externally and when the prior prices are provided by the appraiser themselves (Geltner, 1993; and Diaz and Hansz, 1997).

The purpose of this study is to test additional behavioral finance theories in a real estate context. That is, this study examines two prevalent psychological biases that are hypothesized to cause real estate investors to deviate from purely mathematical thought processes. Specifically, regret aversion and false reference points are empirically tested.

Literature Review

Regret aversion refers to the phenomenon that people keep the status quo because they know from experience that options that seem to be favorable given the apparently correct information at the time the decision is to be made, may later turn out to be less favorable man previously assumed (Samuelson and Zeckhauser, 1988). Regret aversion therefore is closely linked to the theory of omission bias, which holds that people perceive harmful commissions as worse than corresponding omissions and, therefore, prefer omission to commission (Ritov and Baron, 1992). Selection of an alternative also means commitment to the alternative. Psychological commitment claims behavior on behalf of a position, as a change may damage self-esteem.1 When a poor decision is undeniable to ourselves, the natural survival instinct is to downplay the importance of the event or change the way we think about the outcome altogether. That is, we change the reference point from which the outcome is evaluated.2 As Arkes and Blumer (1985) emphasized, upward re-evaluation of the chosen alternative may result in an increased willingness to spend further effort on the alternative as compared to the resources that would have been spent voluntarily if no prior commitment had been made.

In their extensive study on status quo bias, Samuelson and Zeckhauser (1988) collected anecdotal evidence, field experiments, and a number of laboratory experiments. A striking example of "real world" status quo bias is that of a small town in Germany that had to be relocated due to a mining project. As Samuelson and Zeckhauser reported, "Government specialists suggested scores of town planning options, but the townspeople selected a plan extraordinarily like the serpentine layout of the old town-a layout that had evolved over centuries without (conscious) rhyme or reason" (p. 10). In their field studies, Samuelson and Zeckhauser were able to demonstrate status quo bias, for instance, for the enrollment of Harvard employees to health plans. …

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