There are two reasons a potential home seller might balk at selling his house in a down market. First, if the value of the house has decreased past the amount he owes on the mortgage, he’s underwater, and would owe money to the bank after he sells. But even if he has paid off the house, the fear of taking a loss might stop him in his tracks, even if it’s only a loss on paper.
For example, if he purchased the house for $200,000, at the peak of the market, he determined the house value was probably $800,000, and comparable homes are now selling for $400,000. Putting the costs of owning and living in a house aside, he would have a real gain of $200,000, but it feels like a loss of $400,000 from a theoretical peak.
The brain over-emphasizes the effect of a loss, and we are wired to avoid losses if possible. Many home sellers sell their current home at the same time they’re buying another. On average, the disadvantage one has as a seller is offset by the advantage one has as a buyer at roughly the same time. This is why the real estate market is slow to recover, however. People believe the myth about the great financial returns of real estate and rather than sell when they need to, they hold on until they can report that their home ownership was financially successful.
A recent article on NPR’s Planet Money illustrated loss aversion through a coin toss where the winning and losing scenarios were slightly different.
I recently visited Eric Johnson, a professor at Columbia’s Business School. He offered me a sweet bet on the flip of a coin. If the coin came up heads, I would win $6. If it came up tails, I would lose $1. I told him I’d take the bet. But then he changed the terms — if the coin came up heads, I would win $6. If it came up tails, I would lose $4. That bet I didn’t like.
Of course, this is irrational. The bet is still very much in my favor. If I took the bet 1,000 times, I’d almost certainly make a nice profit.
I think the key here is that over time, we know a coin toss will revert to positive performance 50% of the time. Although the overall probability remains the same when you look at one coin toss, there is no time for performance to even out. There is still the chance of losing $4, and it’s a good chance. It’s the same with selling a house. You don’t have the opportunity to sell houses over time so your performance reverts to average.
One problem with this analogy is that while the results of a coin toss are random, your selling price, while perhaps not exact, is relatively well-defined. You know going into the transaction whether you have a paper loss or a gain. While clinging to a house longer than necessary in a market that has fallen is avoiding a guaranteed loss (real or paper), choosing not to take a 50/50 bet when the losing outcome seems too painful is avoiding merely the chance of a loss.
There is also the assumption that the coin toss isn’t rigged. If I offered you the opportunity to win $5,000 if the coin I toss lands on heads or to pay me $4,000 if the coin I toss lands on tails, first you’d ask yourself why I would even offer such a bet. You would consider whether I knew something about the coin that you didn’t know.
I’m sure home sellers often think the real estate industry is rigged. In fact, it is — real estate brokers are the real winners, because they can take a piece of every sale regardless of whether the seller wins or loses. They also have a lobbying group that ensures a favorable environment for real estate transactions.
Would you wait to sell a house at a time when the market is more in your favor, even if it means buying a new house when you’d have to pay more than you would today?
Published or updated February 25, 2011. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.