Mood of the Market

The fields of behavioral economics and behavioral finance are a couple of 21st-century mashups, academia-style, blending observations about the often-irrational financial decisions people make (which, writ large, become economic trends) with insights from the behavioral sciences, from anthropology to psychology, and beyond.

Though these disciplines originated in the ivory tower, they have, in turn, given birth to a number of findings, insights and even mandates for every homebuyer who wants to optimize the dozens, maybe even hundreds, of decisions they'll face at every point on the path to purchasing a home, from when to buy to how much to offer to what type of mortgage to take.

Here are the four most powerful behavioral economic and finance insights with real estate implications, and how you can apply them to level up your own home buying decision-making:

1. Observing willpower basics can help you avoid overspending.

In real estate, overspending can mean any of several things, but there is one definition that is particularly insidious, and it's the simplest: spending more than you can truly, sustainably afford to!

This happens because, over the years, buyers have grown to conflate their lender's decision on how much they can spend with their own decision to make about how much they can afford to spend.

It's like confusing your credit card limit with what is responsible to spend.

Willpower researchers have found that not only does the elusive ability to exercise self-control in the face of temptation actually exist, it can be fostered in some relatively simple ways. This is good news for homebuyers in today's hot market, where multiple offers and a fear of missing out on good deals can create that auction atmosphere that causes otherwise sane and sober spenders to throw every cent they can at their target home.

The theory of ego depletion says that willpower is finite, and can be depleted by putting too many demands on it at once. So, rather than trying to diet, stop biting your nails and start a new cardio regimen all at the same time, most people do better making one willpower-sapping change at a time.

And the same goes with homebuying: If you've had a day where you went to great lengths to bite your tongue to avoid snapping at your kids, and you also had to turn down Girl Scout cookies and birthday cake carbs at work all day, it might not be the right night to decide how much to offer on your home. Instead, ask your agent to connect with the listing agent and let them know to expect an offer in the morning.

Similarly, avoid letting yourself get too hungry or binging on sugary treats during the stress of your house hunt; willpower requires brain glucose, so super-hungry house hunters or those on a sugar rush/crash cycle are liable to make poor decisions at offer-price decision time.

2. Ditch the herd.

Everyone wants to buy low and sell high, especially when buying a home. The challenge is that we all have an innate fear of missing out on both bargains and profits. Our inclination to act on this fear is exacerbated when we hear stories of the steal that our cousin got on a foreclosed home at the bottom of the market, or the cash that is being thrown at our next-door neighbor at the top.

Think about it: When prices are cheapest, and on the decline, demand is low and is hard to drive upwards, because people are afraid to buy a home when they think the price might continue to decline. And the opposite is true: When home prices are rapidly ascending, demand is high, and tends to snowball even higher, as people afraid of missing out on value increases and others afraid of being priced out of the market frantically join the herd and buy, buy, buy!

This is precisely why it's foolhardy as a homebuyer to try to time the market just right. Best practice is to buy when the time is right for you, your family and your finances, then to get educated about market dynamics and use them to inform your strategy on how you execute your purchase, like what price range and area to target, how much to offer and when to lock your interest rate.

3. Overconfidence and real estate are a deadly combination.

Behavioral finance researchers and theorists have devoted a lot of attention to overconfidence: the tendency of some investors and financial professionals to overestimate their ability to pick stocks, trade profitably or otherwise succeed at a given task. In the realm of traded assets, overconfidence cause all sorts of simple, yet potentially catastrophic, behaviors, like making excessive trades, which has been correlated to big time losses over time.

And overconfidence is just as deadly in real estate: Homebuyers who incorrectly gage their own bargaining power, future finances or fix-it prowess can and often do end up in what my mom would call "a world of hurt."

  • Lowball offers or other negotiating strategey (no typo) can result in lost home after home, all while prices go up and your energy and enthusiasm go down.
  • Making mortgage obligations with overly optimistic hopes for your future income or the home's appreciation is exactly what got the last generation of homeowners in trouble.
  • And buying a major fixer when you have no money to hire a contractor and you've never even had any interest in owning, much less swinging, a hammer? It's a recipe for disaster. Didn't you ever see "The Money Pit"?

4. Don't let loss aversion make you forget what you can truly afford.

There is an interesting imbalance in most of our brains, when it comes to our financial decisions: We are more afraid of losing money (and financial opportunities) than we are attached to acquiring gains. That is, our fear of loss is much, much greater than our emotional attachment to potential profits.

In homebuying, this most often manifests when house hunters lose their minds and cut the purse strings entirely to secure a hot home in a hot market. This is the same mindset that has kept homeowners stuck in homes in depressed markets: Some unemployed and underemployed homeowners have even forgone great job offers in other areas, committed to spending what might be dozens of years in the very worst local economic markets, all to avoid short-selling the place and taking a loss.

I've seen people do very, very scary things out of loss aversion, from simply (but devastatingly) overextending themselves to buy homes they can't afford without endangering their financial well-being, to taking mortgages they knew would adjust problematically in 12 months. What's even more dysfunctional, though, is avoiding the "loss" of a target property by taking gifts and loans from relatives who you know upfront will be less than cheerful givers and who you know upfront will never let you hear the end of it.

Tara-Nicholle Nelson is author of "The Savvy Woman's Homebuying Handbook" and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Tara is also the Consumer Ambassador and Educator for real estate listings search site Trulia.com. Ask her a real estate question online or visit her website, www.rethinkrealestate.com.