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March 01, 2010

When Believing Is Deceiving

Sheena Iyengar
S. T. Lee Professor of Business
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Why did subprime mortgage borrowers make the choices they did, even when in many cases their decisions made them worse off than they were to begin with? To answer this question we need to take a closer look at how people determine what is most in line with their self-interest — and how they fail.

Self-Interest Can Be Led Astray

We continually draw on the process of detecting patterns and making order from chaos when we are trying to figure out which choices are in line with our self-interest. In order to choose effectively, we ask ourselves — consciously or subconsciously — How does it look? We’re usually pretty accurate, but there are some systematic ways in which our ability to determine what’s true might fail us, which can have dire consequences. Our pattern-detection abilities are just as good at finding apparent patterns in purely random events as they are at finding actual patterns. These tendencies can also lead us astray when the true pattern is more complex than we realize.

We also consult our emotions from the very beginning, asking ourselves, How does it feel? We use the information we collected in the former process as a backdrop for assessing our feelings about options confronting us and their potential outcomes, and we make the choice that we feel will have the most positive consequences. But as with pattern detection, there are some systematic ways in which consulting our emotions can lead to error. It’s easier to feel the present consequences of a choice than its future ones, so we give greater weight to the former. However, decisions based on present desires may not be well suited to our modern world, where the ultimate goal is to be as satisfied with the long term as possible.

Buying Into the Illusion

So what kind of patterns and feelings were people detecting when they looked at the costs and benefits of owning a house?

Owning a home had traditionally been seen as a safe investment for the average person, almost guaranteed not to lose value over time. Indeed, the inflation-adjusted average home price had stayed almost constant at $110,000 (in today’s dollars) between the end of World War II and 1997. At that point a new pattern emerged, with prices nearly doubling to about $200,000 between 1997 and 2006 due to a perfect storm of demand-increasing factors: low interest rates, the creation of new financial products based on mortgage income and aggressive lending practices to name just a few. Many local markets grew even faster, especially those in California, New York and Florida.

Seeing this dramatic and consistent growth convinced people that this was a truth about the world — that prices would continue to rise in the future. A nationwide survey conducted by Fannie Mae in 2004 found that 70 percent of Americans considered buying a home to be a safe investment, nearly double the percentage that considered a 401(k) retirement plan to be a safe investment.

Combined with the more immediate and tangible benefits that purchasing a home offers, real estate began to look like an amazing investment. People buying a home to live in for years to come were afraid that if they didn’t act immediately their dream home would become dramatically more expensive, while speculators saw a golden opportunity to get rich quickly. They rushed to enter the market as quickly as possible, driving prices still higher.

But while the upward trend in housing prices could have been consistent with a pattern of constant increases in the future, or moving toward a new and permanently higher plateau, it could have been equally consistent with another pattern that is more variable and difficult to recognize: boom and bust, or a “bubble.” In a bubble situation people feed off one another’s enthusiasm, pushing prices far higher than the true value of the assets in question. Eventually it becomes clear that they’re overvalued, at which point the bubble pops as everyone rushes to sell their assets.

Our pattern-detection abilities and feelings can serve as a powerful source of information about the subtleties and complexities of the world around us, but once we’ve come to see a particular pattern we subconsciously want it to be right. It feels better to think that we’ve unlocked the mysteries of the universe and of the future, and when the pattern promises wealth or other forms of success, as in the case of the subprime market, it’s even more tempting to believe in.

Sheena Iyengar, the S. T. Lee Professor of Business, is the author of The Art of Choosing (Twelve, March 2010), which was published this month. Watch a video interview with Professor Iyengar about the book.

Photo credit: The Truth About Mortgage