Saturday, June 02, 2007
How Psychology of Loss Affects Present Home Sales
Normally our market reports deal with pretty tangible information - how many homes sold this month compared to last, what percentage increase in the number of listings on the market, etc. This report concerns a softer, fuzzier topic - psychological factors we use to confront loss. Rather than represent this material as literal fact, we offer it as information for our buyer’s and seller’s consideration when they negotiate purchases or sales of real estate.
Burton Malkiel’s classic book about stock market investing, ”A Random Walk Down Wall Street”, contains a section devoted to behavioral finance. Malkiel cites the work of two psychologists, Daniel Kahneman and Amos Tversky, who disputed whether people are as rational as the economic models assume. He discusses some of the irrational ways we use to justify decisions meant to increase our profits or decrease our losses. Among these are overconfidence (80-90% of college students consider themselves to be safer, more skillful drivers), biased judgments (seeing trends that no longer exist based on past performance of stock or housing markets), and herding (following the conventional wisdom - such as daytrading and the furious chase after internet stocks in the late ‘90s). His section concerning loss aversion relates directly to our current housing market.
In a coin toss game where I offer to pay you $100 if it comes up heads but you pay me $100 if it comes up tails, researchers found that most people would not play the game. They had to increase the positive payoff to $250 (heads - I pay you $250, tails - you pay me $100) before a majority would play. Thus they concluded that a dollar loss was about 2.5 times as painful as a dollar gain was desirable. When confronted with a game where loss is certain, individuals prefer to gamble. For example in a study where individuals were offered the choice of A) Paying $750 or B) Draw Straws where they have a 75% chance of paying $1000 or a 25% chance of paying nothing, 90% chose B, even though the probabilities of A and B are the same. This same hope against the odds causes sellers to hold on to a higher price waiting for that special buyer who will pay more while losing out on other buyers who want to pay less.
A study of 10,000 clients at a large brokerage house showed a clear disposition among investors to sell their winning stocks and to hold on to their losing investments, avoiding the more painful effects of regret and loss. This aspect of our human nature is not rational and can work against an investor or home seller if not challenged.
“A similar reluctance to take losses appears to be evident in the residential housing market. When house prices are rising, the volume of sales rises and houses tend to sell quickly at asking prices or higher. During periods of falling prices, however, sales volumes decline and individuals let their homes sit on the market for long periods of time with asking prices well above market prices. Extreme loss aversion helps explain sellers’ reluctance to sell their properties at a loss.” Burton Malkiel, A Random Walk Down Wall Street
To overcome this reluctance to take losses, home sellers need to reframe on a larger scale the loss and its impact. What will be the income and costs associated with renting the property and not selling? If you have to move, will you still be ahead after several years if you buy a new home without selling and rent this one? Are you willing to rent at your new location so you can hang on to the house you don’t want to sell now? Do you have the time and desire to become a property manager? Have you accounted for the costs of maintaining the condition of your property after you rent it? How long in a new situation will it take to make up for this loss?
Homeowners who have held their properties for more than a couple years will in many cases not be taking an actual loss, only losing compared to their perceived peak market home value. They are willing to bet that the market will soon turnaround and resume its upward climb rather than selling for less now.
None of us is immune to this protective aspect of our human nature. However, once you become aware of the tendency, it might be beneficial for you to ask the questions and consider the long term impact of holding on to avoid the pain of loss.
Statistics not compiled or published by NWMLS
