Short-Term Investors Help Inflate Bubbles

When asset bubbles inflate, rising prices suck in a specific market participant: investors with short investment horizons. And once drawn into a market, these short-term investors “have the ability to destabilize financial markets,” write Northwestern University’s Anthony A. DeFusco and Charles G. Nathanson and Chicago Booth’s Eric Zwick.

Investors are more likely to use recent market performance to extrapolate what will happen in the short term than they are to extrapolate about the long term, research has established. But it’s less clear how specific time horizons affect this tendency. To shed more light on this, the researchers developed a model that extrapolates expectations based on investment horizons ranging from one year to five years to a permanent horizon.

The model demonstrates that investors with a horizon of only a few years expected greater gains than investors with much longer expected holding. This suggests that when prices were rising, the heightened expectations of short-term investors caused them to pile in—and that’s exactly what happened.

In the 2000–05 US housing boom, the price increase in metro areas rose along with the proportion of short-term investors to long-term investors.

As home prices doubled, the total number of homes sold that had been owned for less than three years nearly doubled, accounting for 42 percent of the change in sales volume, the researchers find. In 2005 alone, the number of homes flipped after one year was more than double the number of quick flips that had occurred in 2001. “Buyers looking to make a ‘quick buck’ are drawn to rising prices more than those buying for the long run,” the researchers write.

The relationship of price and volume works in reverse, as well. Once prices cooled, so too did home flipping. By 2007 and 2008, the number of sales made by people buying and selling a home within one year had sunk below levels seen during the 2001 recession.

The research also finds that during the frenzy, more than half of home flipping was generated by people who never lived in the homes they purchased. An annual survey revealed that people who invested in real estate owned homes for shorter periods than people who occupied homes they purchased.

And investors should closely watch the direction the total number of home sales are trending. In the housing boom, volume trends presaged price trends by 15 months, the researchers find.