The Frontal Cortex

Supply and Demand

Loss aversion is so easy to understand – it can be explained using a coin flip in ten seconds – and yet it manages to explain so many anomalies of modern life*, from the 4th down habits of football coaches to the collapsing real estate market:

The professors gathered data on almost 6,000 Boston condominium listings from 1991 to 1997 and showed that for essentially identical condominiums, people who had bought at the peak and were facing a loss generally listed their properties for significantly more than those who had bought at a time when prices were lower.

Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

In classical economics, that’s not supposed to happen, but the episode did comport with the behavioral economics theory of loss aversion: people have a visceral — some might say “irrational” — hatred of losing money. They try to avoid doing so, even when it goes against their own best interests.

That’s Austan Goolsbee in the Times. But is the reticence of home sellers a bad thing? It seems to me that the alternative is an instant deflation stock-market style, where the value of the investment can drop 5 percent in a single day. Now that would be depressing. Can you imagine coming home to a pile of bricks that is plummeting in value? It’s one thing to lose paper money in a stock portfolio; it’s another thing to live inside your losses. I think the loss aversion of homeowners is particularly strong, if only because nobody wants to get depressed every time they see their driveway.

*Perhaps the only psychological law which is equivalently simple and yet even more potent is adaptation/habituation. What do you think?

Comments

  1. #1 Jorge Gajardo Rojas
    September 24, 2007

    I wonder if money loss aversion is diferent of other kind of losses including emotional losses.?

  2. #2 Jonathan
    September 24, 2007

    I wonder if money loss aversion is different of other kind of losses including emotional losses.?

    You can’t think of these things in terms of some arbitrary quantification. It all has to do with the neurotransmitters. Essentially, how much dopamine is released.

    Maybe that explains loss aversion on a bio-chemical level? The dopemine released when you succeed is only half as potent as the neurotransmitter released when you lose?

  3. #3 Apium
    September 24, 2007

    My mother has been a realtor for over 20 years, so I’ve had an opportunity to see both peaks and valleys of the housing market. She’d always say that if you want a property to move in a down market, you can’t price it too high. And at the height of the seller’s market a couple of years ago, potential buyers were writing contracts like eBay bids, with escalation clauses and no need for home inspections.

    Another factor to consider in the behavior of the Boston homeowners is that for many people, a house is the largest investment of their life. You expect property values to rise over time, and plan to use the equity from your mortgage to step up to a larger and more costly house next time. When the market is in a downturn, you still can’t give up the perception that you deserve more money, but the market sets the prices. A house listed above the market is just going to sit there until the owners are willing to forego their anticipated profits.

  4. #4 elliott
    September 25, 2007

    Perhaps the Law of Effect is a bit easier to relate to?
    (http://en.wikipedia.org/wiki/Law_of_effect)

    I think the real estate example is a great story about how people don’t like losing things, but it strictly doesn’t demonstrate loss aversion – to do that, we’d have to see how their preferences work in the gain domain as well (i.e. if “losses loom larger than gains”).

  5. #5 tekel
    September 25, 2007

    Can you imagine coming home to a pile of bricks that is plummeting in value? It’s one thing to lose paper money in a stock portfolio; it’s another thing to live inside your losses.

    Anyone who bought a house in the last 36 months and hasn’t yet sold it can probably imagine it pretty well, because you’ve just described exactly what their lives are like. That is, you’ve described what their lives will be like until the bank forcloses after their ARM loan resets to LIBOR market rates and they get evicted.

    I think the loss aversion theory has merit in certain very constrained housing markets, such as Boston or the SF Bay area: prices in the actual city of SF never really go DOWN, per se. They just flatline until the market picks up enough to once again support the irrationally inflated prices. But if you’re far enough outside the actual metropolitan area, right now prices are dropping like David Vitter’s pants in a Baton Rouge brothel, in part because private party sellers are forced to drop their ask in order to compete with banks that are auctioning repos at very very low prices.