"Loss Aversion"

Psychology, not Economics,
Holds Key to Buyer Behavior

Economists trying to explain the slow housing market may be barking up the wrong (academic) tree. Rather, it is their colleagues in the psychology department who may have the best insight into what's underlying buyer's actions (or lack thereof): a behavioral phenomenon called "loss aversion."

In study after study dating back decades, psychologists have documented that people perceive gains and losses very differently. Irrational as it may be, a financial loss causes the average person roughly twice as much psychic pain as a similar-size gain causes them pleasure. As a result, people are far more likely to govern their affairs to minimize pain than to maximize pleasure.

What's that got to do with the current buyer's market?

Basic math suggests that a weak market is a bonanza for move-up buyers. The middle-market, $500k house they have to sell may be off 10%, or $50k, but the upper bracket, $1 million house they aspire to buy is also marked down 10%. Ten percent off of a much more expensive house translates into a much bigger absolute discount -- in this case, $100,000. Truth be told, given the recessionary environment and tighter credit markets, in many Twin Cities neighborhoods the formerly $1 million house could probably be had for the high $800's now.

The Move-Up Conundrum

So why aren't the move-up buyers moving up? Because the $50k loss they're contemplating hurts more than the $100k (or more) they stand to save.

It's impossible to prove whether loss aversion explains move-up buyers' hesitation. However, a good test would seem to be the behavior of buyers not affected by loss aversion (or at least not as much).

Fortunately, such a group exists: they're called "first-time buyers." While first-time buyers are understandably nervous about the market declining after they buy (just as loss aversion theory predicts), by definition they don't have to realize a loss on an existing property first.

Based purely on anecdotal data I've seen, the lower end of the market does in fact seem to be much healthier than the middle and high ends. Neighborhoods that traditionally attract first-time buyers -- Longfellow, Nokomis, parts of Kingfield, St. Louis Park's Birchwood neighborhood (west of 100) -- have surprisingly little for sale under $200k or so that has a decent amount of space (more than 1,000 FSF), some kind of yard, has been reasonably updated, and can legitimately be called "move-in ready."

Of course, it's also true that there are a lot more people who can afford a $200k house than a $1M house, especially in a soft economy.