THE BLOG

LOSS AVERSION THEORY AND THE HOUSING CRISIS

09/21/2008 05:12 am ET | Updated May 25, 2011

I recently finished reading Ori and Ron Brafman's book, The Sway (Doubleday, 2008) the premise of which is that people make decisions (or don't) based on factors ("psychological undercurrents") of which they are not necessarily aware.

One example is loss aversion - the tendency to go to great lengths to avoid loss, even when by any logical analysis one should take a loss and move on in life. A common example is stock market behavior - many investors will not sell a stock at a loss even though all signs are that the stock price is going further south. These people just hate taking a loss; as long as they still own the stock, they can convince themselves that the price will recover and they will never incur a loss.

Much of what is going on right now in the housing crisis has to do with loss aversion.

Many sellers are refusing to acknowledge that housing prices have fallen. By keeping their prices unrealistically high, they do not have to acknowledge a loss. And so houses sit, inventories rise and sales numbers go down. The media picks up on these numbers and writes (ad nauseum) about bad housing data ... prospective buyers read these articles, get spooked, stay on the sidelines and so on.

Recently I discussed my theory that seller loss aversion was making the housing crisis worse with a real estate executive and she disagreed. Here was her take:

"Some areas of the country have such limited demand right now that there is no point to sellers lowering prices. By doing so, they communicate to the buyer community that prices are dropping which in turn reinforces buyer's beliefs that prices will continue to drop. Until there is some acknowledgement among the media or the buyer community that prices have hit bottom, there is no point to a seller dropping his or her asking price."

On reflection, I think that the housing executive was correct. In fact if all sellers in a market who did not have to sell kept their asking prices firm, perhaps the housing crisis would start to end. In other words, once buyers start to believe that the free fall is over, they will start to buy and then the free fall will in fact be over.

The other potential saviors of the housing market are the speculator and investor communities. If prices get low enough, the speculators (who to some degree created the housing crisis) will start buying and, in some cases, in bulk. A recent report in the Wall Street Journal spoke of a company in San Diego planning on buying several hundred houses to hold and resell.

And then there are the investors. If prices fall to the point where one can buy a house and rent it out at a reasonable return (+/- 10% on capital invested), the investors will start buying houses.

Although I have taken a lot of heat for suggesting that housing prices will stabilize by the end of the year, I continue to feel that educated sellers, risk-taking speculators and rational investors will prove me right within the next four or five months.

Jim Randel is the author of the about-to-be-published book, The Skinny on the Housing Crisis (Clover Leaf, 2008) and a believer in the market's ability to correct itself sooner rather than later.