The latest report on home sales is bleak:
Sales of new homes fell in June for the seventh time in the past eight months, more proof that the worst housing slump in decades is getting deeper.
The Commerce Department reported Friday that sales of new single-family homes dropped by 0.6 percent last month to a seasonally adjusted annual rate of 530,000 units following an even bigger 1.7 percent fall in May.
The decline was slightly smaller than had been expected and sales were revised up a bit for May. Even with those changes, new home sales are down by a sharp 33.2 percent from a year ago.
At first glance, now would seem like an excellent time to buy a home. In most urban areas, home prices are down at least 20 percent from their peak in 2007. Shouldn’t lower prices lead to increased demand? After all, interest rates are still low by historical standards.
The problem, of course, is that people are afraid that the real estate market will only get worse. No one wants to pay interest on an investment that continues to decrease in value. This is a textbook example of loss aversion, which is the kahnemanandtversky principle that losses hurt more than gains feel good. Kahneman and Tversky stumbled upon loss aversion after giving their students a simple survey, which asked whether or not they would accept a variety of different bets. The psychologists noticed that, when people were offered a gamble on the toss of a coin in which they might lose $20, they demanded an average payoff of at least $40 if they won. The pain of a loss was approximately twice as potent as the pleasure generated by a gain.
So far, so obvious. Losing stuff sucks. But I think some recent research on loss aversion can shed some light on the real estate malaise. The problem for home buyers right now is the possibility that they might lose something in the distant future. They think about how awful it will feel to live in a home that’s worth less than their mortgage. But, according to a study by Dan Gilbert and colleagues, that prediction is actually false. As Gilbert notes, loss aversion is an affective forecasting error. We think it will really hurt to buy a home that’s decreasing in value, but it’s actually not that bad (at least, it’s not that bad until foreclosure hits). Here’s the abstract:
Loss aversion occurs because people expect losses to have greater hedonic impact than gains of equal magnitude. In two studies, people predicted that losses in a gambling task would have greater hedonic impact than would gains of equal magnitude, but when people actually gambled, losses did not have as much of an emotional impact as they predicted. People overestimated the hedonic impact of losses because they underestimated their tendency to rationalize losses and overestimated their tendency to dwell on losses. The asymmetrical impact of losses and gains was thus more a property of affective forecasts than a property of affective experience.
The key to ending the housing bust, then, might be as simple as getting people to realize that their fear of buying a home is mostly the fear of a cognitive illusion. Losing something always hurts, but it doesn’t hurt nearly as much as we think it will.