As an investment vehicle, housing has a pretty mediocre track record, but people love to think of their house (or housing in general) as a good general investment to have. Even after the great crash, it’s coming back as an investment idea.What explains this?
PHD candidate Thomas Alexander Stephens and economist Jean-Robert Tyran did a story called ‘At Least I Didn’t Lose Money’ (.pdf) that discovered a psychological explanation for this phenomenon.
Stephens and Tyran summarized their findings over at VoxEU.
The gist is that people have a strong psychological aversion to nominal losses, and that if presented with two transactions that give people identical real losses (meaning inflation adjusted) people will consistently rate more favourably the transaction that gave them an inflation-adjusted gain.
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.
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.
The gist is that, excluding noise, and the 17% of the survey takers who saw no difference between transactions that yielded the same nominal loss, about 60% of respondents consistently see an advantage engaging in a transaction that gives them a nominal gain, even if the loss is “real” after inflation.
The researchers then did the experiment again, and found that if you flipped things, and gave them two transactions that offered up a real return, people didn’t have a strong preference between identical real returns.
Their conclusion: Although houses don’t have a strong history of real, above-average returns, they do have a strong history of nominal gains, thus from a psychological standpoint, they make for a strong return.
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