The Campbell Real Estate Timing Letter
The only timing advisory for San Diego real estate investors

Mass Psychology:
The Key to Real Estate Market Cycles

Every trend must go too far and evoke its own reversal.
                                            - Hercaclitus, 500 B.C.

           There are powerful but unseen psychological forces at work that affect – and are affected by – the ever-changing real estate cycles.  This is because humans behave differently toward market cycles than what most people think, or what many of us were taught to believe in our Economics 101 classes. 

No, we human beings are not the objective creatures we often believe we are.  We don’t always act in our own rational, economic self-interest.  Instead, human beings are psychological beings, and are driven primarily by the immediate experiences at hand – be it pain or pleasure.  These experiences, however, cloud our perception of risk.  In doing so, they sabotage our attempts to make wise investment decisions.  In fact, the presence of mass market psychology repeatedly compel us to do just the opposite of what we should do in order to maximize economic pleasure (make investment profits) and minimize economic pain (avoid investment losses or lost profits).

For example, when people are currently experiencing economic pleasure – say during a prolonged upturn in the real estate cycle – they become overly optimistic and their perception of risk fades away.  However, when people are currently experiencing pain – say during a long downturn in the real estate cycle – they become overly pessimistic and perceive real estate as more risky than it actually is.  

Misplaced Perceptions of Risk

These resulting perceptions of risk not only affect the way people view the real estate market, but how irrationally they act. This phenomenon becomes even more evident as we reach major turning points in real estate cycles, where everyone seems to want real estate when it is expensive, yet very few want it when it is cheap.

The reason for this is simple:  the mass psychology of optimism and pessimism, once set into motion, takes on a life of its own and feeds upon itself. That is, during upturns in real estate cycles, optimistic psychology takes a hold of the market and this induces more and more people to adopt optimistic beliefs and expectations.  People start to believe that what is happening now will continue to happen, and thus they come to see less risk than actually exists in the market.  As a consequence, people eventually become excessively optimistic about the future, which causes them to pay too much money and incur too much debt for real estate, and take bigger risks than they should be taking.

Knowing that markets will do everything possible to prove the greatest number of people wrong, these overly optimistic expectations are what lay the groundwork for a downturn – or bust – in the real estate cycle.

            When a downturn in the real estate cycle does arrive, this sets off a whole new wave of emotions into motion – the psychology of pessimism.  Now people are driven by risk avoidance, in order to minimize pain.  This continues until people become excessively pessimistic, and real estate prices fall to bargain levels.  Even at low prices, there are few takers.  People come to see more risk than actually exists.  This, in turns, sets the stage for another market cycle of expansion and prosperity – which catches most people in disbelief and by complete surprise.

Sell Irrational Exuberance . . . 
Buy Irrational Despair

            Correctly measuring risk relative to potential rewards is how good investment decisions are made.  Mass psychology, however, is always at work in market cycles, producing irrational behavior that sabotages objective (and wise) decision-making.

            Great investors do not become great by engaging a follow-the-crowd mentality and giving in to the forces of mass psychology.  They know that things are not always what they seem. Just as too much pessimism sets up the conditions for an upturn in the real estate cycle and a long rise in property values, over-optimism sets up the conditions for a downturn in the market and a fall in real estate prices.

            To combat these psychological pitfalls, and to avoid being one of the crowd, you must be able to adjust to the changing degrees of real risk … not perceived risk.  To do this, an investor needs to adopt an economic strategy that shifts from an offensive to a defensive posture as market conditions warrant.

In the cyclical world of real estate, the biggest profits are made when you buy deeply discounted real estate when nobody wants it, and then sell richly priced real estate when everybody wants it.  In other words, you need to train yourself to be an objective decision-maker that knows how to recognize real risks and identify true opportunities to both buy and sell.  

Subscribe to The Campbell Real Estate Timing Letter and you’ll be able to capitalize on the irrational behavior of others who are unprepared to play this ever-changing game.  

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