Why the bubble will take some time to sort itself out

Basic economics teaches us a lot about the decisions we make. Take the simple example of supply versus demand. Most people are aware that if supply is greater than demand, prices fall. Which turns out to be true in an abstracted economical construct.

The stock market is almost such a construct. It is as close to pure economics as you can possibly get. When no one wants to buy a certain stock, it's price will fall until someone does. There is no waiting time, time to pitch your stock to a potential buyer, it simply falls until it is attractive to someone. The same is true in reverse, if everyone wants the stock, the price will rise until enough owners are willing to sell. When the average investor buys or sells, they don't negotiate or consider multiple offers. The market economy is abstracted away to the point where the investor is told what the stock is worth and that's what they use.

So why do houses take so long to sell? If you can buy a stock any day and sell it any day, why does a home sit on the market for weeks or even months? Simply put, it's because economics fail to take into account the power of emotion and perception.

There is a game anti-economists play to prove that humans are not economical. It's called The Ultimate Game, and it's really quite simple. Take two strangers off the street, we'll call them Thing 1 and Thing 2. Put $1000 on the table and tell Thing 1 to divide it however he wants between them. Then Thing 2 gets to accept or reject the offer. If he accepts they each take their money and walk away, but if he rejects they both go home with nothing. It's an awfully simple game.

In the world of conventional economics, Thing 1 should maximize his own gain and offer Thing 2 $1, while keeping $999 for himself. Thing 2 might not like this offer, but classical economics say that he should realize that $1 is better than nothing and accept the offer. Too bad it never actually works out that way. In tests throughout many countries, Thing 2 always rejects the minimum offer. In fact, he rejects more than half of the offers consisting of lower than 30% of the total. Why? Doesn't he know that going home with $1 is better than going home empty handed?

To answer that question we need to put the game into a void. Go up to a stranger (or even someone you know) and offer him a dollar. Odds are high that he will accept it. So obviously the dollar itself isn't the problem. Let me pose two theories of why Thing 2 wants more than the minimum:

1. When the money is first mentioned, Thing 2 immediately perceives half of the money to be his. When the lowball offer comes in, Thing 2 perceives that offer as a loss.
   
2. When Thing 1 makes a lowball offer, Thing 2 compares his gain to Thing 1's gain and is insulted.
   

Both scenarios are interrelated and both result in the same way, Thing 2 turns down an offer that would have benefited him, simply to punish Thing 1 for being unfair. But for the moment, I want to focus on the first theory.

In this theory, Thing 2 hears the rules of the game and realizes that it's a cooperative game where each player only benefits when they work together. Thing 2 immediately perceives half of the money as his, after all Thing 1 gets nothing without his cooperation. When the lowball offer come in, instead of seeing the offer as a $1 profit, he views it as a $499 loss. Emotion and perception rule over hard logic.

I hope now you've seen the connection with real estate. The tremendous news rush about the housing boom lead many Americans to have an inflated perception of the value of their homes. In addition they've seen houses all around them sell for enormous profits, and naturally they then perceive those profits to be theirs as well (once they sell).

This is the reason why, instead of home prices falling as much as they should, homes have been sitting on the market for much longer periods of time. Everyone knows that the sellers have over-inflated opinions of their home's value, but they refuse to readjust their views because they don't want to take a "loss". So they leave their over-priced homes on the market, just waiting for either the general prices to rise back to their previous levels or for some greater fool to come along. Eventually most of these people will reach a point where they can no longer afford to wait and will end up in an even worse situation, selling for a "loss" as a "motivated" seller.

One lesson that investors can take from this is simply that some people are more logical than others. As an investor, if you received that offer for less than you wanted, you should be able to properly analyze the situation. I know you were hoping for a $500 profit, but is that realistic? Or is the current profit the best you can hope to get? The same goes for our investments. We always picture our future profits in our head, and are disappointed with under performing assets. We need to release our expectations when we are making business decisions, and just deal with the facts at hand in a logical, economic way.

Even the small profits are profits too.