In the wake of
the economic crisis that began in 2007, homeowners in many countries
have faced substantial losses. Prices have fallen in both nominal and
real terms. In the US, for example, house prices in the first quarter of
2012 were down more than 40% in real terms from their peak (Shiller
2012).Nevertheless, housing remains a popular investment
1.
This popularity is surprising because, over the post-war period, US
house prices have been essentially flat in real terms while the US stock
markets have risen more than fourfold in real terms over the same
period
2.
House prices and psychology
The change in market
value of the asset is of course only part of the overall return on
investment – housing provides housing services and shares typically pay
dividends
3.
Nevertheless, the market value is important, particularly in
psychological terms, because of the possibility of losses. It is well
established that losses loom larger in people’s minds than corresponding
gains (Kahneman and Tversky 1979), but the results of our study suggest
a particular dislike of losing money – that is, an aversion to nominal
losses.
When viewed in
nominal rather than real terms, the capital gains from US housing look
more appealing. From 1946 to 2012, nominal house prices showed a 12-fold
increase. On an annual basis, housing investments have mostly resulted
in gaining money (in 58 out of 66 years), while at the same time
producing real losses more often than not (in 36 v 30 years)
4.
Perceptions of investments
In a recent CEPR
paper, we show that perceptions of housing transactions are shaped by
gaining versus losing money, even when real losses are held constant.
Our research builds on evidence from US housing markets showing that
homeowners are reluctant to sell when facing nominal losses (Anenberg
2011, Engelhardt 2003, Genesove 2003, Genesove and Mayer 2001). Our
survey experiment, with a large, heterogeneous sample, adds to these
studies by relating evaluations to detailed information about decision
makers and by clearly pinning down the role of nominal losses (as
opposed to nominal changes more generally), using controlled variation
of the environment.
The starting point
of our paper is the fact that, in the presence of inflation, real and
nominal losses need not coincide. To illustrate, imagine buying a house
for $200,000 in cash, and selling it several years later for $170,000.
Without inflation, the nominal and real losses will coincide at 15%,
irrespective of the holding period. With even low, stable inflation,
however, the nominal loss will rapidly disappear. If inflation is 2%, a
real loss of 15% will become a nominal gain within nine years.
Measuring perceptions
To measure the
effect of nominal gains vs. losses on perceptions, we present subjects
with hypothetical housing transactions involving the purchase and
subsequent sale of a house, and ask them to evaluate the
advantageousness of these transactions. None of the transactions are in
fact advantageous: they all involve smaller or larger real losses.
However, each real transaction is presented twice (on separate screens);
once with low inflation, so that it involves losing money (a nominal
loss), and once with high inflation, so that it involves gaining money
(a nominal gain).
We then take
differences between evaluations of a given real loss when presented as a
nominal gain and nominal loss, and average them. This gives us an index
of nominal loss aversion – a number indicating the strength of a
subject's dislike of losing money – for each subject.
Figure 1 shows the
distribution of the nominal loss aversion index. A subject concerned
solely with real gains or losses would have an index of zero, as indeed
do 17% of our subjects. The rest, however, are heavily skewed towards
positive values, with 73% of the index values being positive
– indicating a dislike of losing money – against only 10% that are
negative. Treating the 10% as symmetrical noise, about 60% of our
subjects prefer identical real losses when they gain rather than lose
money.
Figure 1. Distribution of nominal loss aversion index
A unique advantage
of our subject pool is the availability of detailed official
socioeconomic data from the National Bureau of Statistics (Statistics
Denmark), as well as the results of cognitive and personality tests.
This data set allows us to identify which sorts of people are prone to
nominal loss aversion.
Within our sample,
we find that subjects with more education and higher incomes tend to be
less likely to let monetary gains or losses influence their evaluations.
At the same time, there is no significant difference between those who
own property and those who do not, suggesting that this bias is not
eliminated by experience
5.
Cognitive measures
are particularly strongly correlated with nominal loss aversion.
Subjects with higher cognitive ability are far less likely to be
influenced by purely nominal differences. The most important aspect of
cognitive ability is not intelligence per se, but cognitive reflection
(Frederick 2005) – a tendency to rely on slower, more deliberative
cognitive processes rather than rapid, intuitive ones. Taken together,
our findings on education and cognitive reflection suggest that there
may be scope for reducing nominal loss aversion through improvements in
financial education.
Gaining or losing money is key
To separate a
dislike of losing money from simple nominal thinking, we ran a second
survey experiment with transactions involving both real losses and real
gains. We duplicated the first experiment, but added a second treatment
in which all of the real losses were changed to equivalent real gains.
Struck by the powerful effect of nominal loss aversion observed in our
first experiment, we were also curious to learn if the effect of nominal
loss aversion would persist if the scenarios were presented to subjects
in a highly transparent way, on a single screen. We find that it does.
Figure 2 shows
average evaluations of the housing transactions in the second
experiment. The two leftmost bars show the average evaluations of real
losses, and the two rightmost bars show the average evaluations of real
gains. The light bars represent transactions with low inflation, and the
dark bars transactions with high inflation.
Figure 2. Evaluations of housing transactions at high vs. low inflation, real losses (left) v real gains (right)
Note: Average evaluations by real and nominal treatments, with 97.5% CIs for means, and nominal GAIN or LOSS.
Comparing the two
bars on the left with the two on the right, it is clear that real gains
are viewed more favourably than real losses, as should be the case from
the perspective of standard economics. At the same time, a comparison of
the first two bars shows that evaluations of losses are shaped by
gaining or losing money. Identical real losses are viewed more
favourably when they involve gaining rather than losing money.
In contrast to real
losses, higher inflation has essentially no effect on evaluations when
holding real gains constant (compare the third and fourth bars). This
contrast (the two bars on the left are different, the two on the right
are not) shows that subjects are not simply thinking in nominal terms,
but rather dislike losing money.
Conclusion
Many people view
housing as an attractive investment with good potential, despite meagre
real capital gains over the long run. We suggest nominal loss aversion
as a psychological mechanism that can help to explain the surprising
popularity of housing as an investment. Using data from a survey
experiment, we find that evaluations of housing transactions are shaped
by gaining or losing money. We find no evidence that property ownership
reduces this bias, but do find strong evidence that more education and
greater cognitive reflection do. These results suggest that better
financial education may reduce this bias towards overinvesting in
housing.
References
Anenberg, E (2011), “Loss Aversion, Equity Constraints and Seller Behavior in the Real Estate Market”, Regional Science and Urban Economics, 41(1), 67-76.
Engelhardt, G V
(2003), “Nominal Loss Aversion, Housing Equity Constraints, and
Household Mobility: Evidence from the United States”, Journal of Urban Economics, 53(1), 171-195.
Fannie Mae (2012), “Fannie Mae National Housing Survey”, First Quarter.
Frederick, S (2005), “Cognitive Reflection and Decision Making”, Journal of Economic Perspectives, 19(4), 25-42.
Genesove, D (2003), “The Nominal Rigidity of Apartment Rents”, Review of Economics and Statistics, 85(4), 844-853.
Genesove, D and C Mayer (2001), “Loss Aversion and Seller Behavior: Evidence from the Housing Market”, Quarterly Journal of Economics, 116(4), 1233-1260.
Hasanov, F and D C Dacy (2009), “Yet Another View on Why a Home Is One's Castle”, Real Estate Economics, 37(1), 23-41.
Kahneman, D and A Tversky (1979), “Prospect Theory: Analysis of Decision under Risk”, Econometrica, 47(2), 263-291.
1 A
survey by Fannie Mae (2012) in the first quarter of 2012 found that 58%
of US citizens viewed housing as an investment with ‘a lot of
potential’, and 65% viewed it as a ‘safe’ investment. By comparison, 55%
viewed shares as an investment with ‘a lot of potential’, and only 15%
viewed them as ‘safe’.
2 From 1946 to the
start of 2012, US house prices increased in real terms by about 7%
(Shiller 2012). The house price data refer to individual properties sold
more than once, to control for changes in housing characteristics over
time. The stock market figure is the Dow Jones Industrial Average
(DJIA).
3 Other relevant
differences include liquidity, transaction costs and taxation. See
Hasanov and Dacy (2009) for a comparison of overall returns from
1952–2005.
4 Excluding the
post-bubble price declines from 2006–2011, housing gained money, on
average, in 57 of 60 years. The DJIA, in contrast, was more likely to
provide positive than negative annual real capital gains (41 years v 25
years), but viewing these gains in nominal terms makes little difference
(positive nominal gains in 47 years v negative in 19).
5 The lack of an
experience effect is perhaps not surprising, since the number of
transactions over a lifetime tends to be relatively low.
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