A few years ago, two very brilliant American economists – Amos Tversky and Daniel Kahneman -conducted an experiment in which they invited people to buy and sell mugs. What they discovered goes a long way to explaining what is happening in the property market today.
Now, selling mugs may not sound that closely related to selling houses, but give me a moment and you’ll soon see why the experiment is relevant to the Scottish property market in 2012.
Tversky and Kahneman brought together a group of students. They gave a third of the students – selected at random – a decorated mug and asked them to set the price at which they would be willing to sell the mug. If the mug didn’t reach that price, they took it home.
The other students were given the option of getting the mug or a sum of money. They were asked to indicate at what ‘price’ they would prefer the mug to the money.
It turned out that those with the mugs would hold on to them unless they got $7 or more for their mug. Those without preferred the money unless they could get the mug for around $3.
In other words, the ‘sellers’ preferred the mug to cash – even though they would walk away with just a mug if they set their sights too high. Those without a mug preferred cash, even if it was a relatively small amount.
The Endowment Effect
What the experiment revealed was that people tend to value what they have more highly than things they don’t currently own. If you own something, your perception of its worth is likely to be higher than that of others and vice versa. In academic circles, this is called the ‘endowment effect’.
You can see the Tversky and Kahneman paper here.
This is also closely related to what is known as ‘loss aversion’. This is the observation that we will fight much harder to avoid making a loss than we will to make a profit. Psychologically, we feel the ‘harm’ of losing £1,000 much more than we value gaining an extra £1,000.
These two observations are powerful psychological forces currently driving the property market.
Firstly, we tend to value our current home more than a future home we might buy if we sold our existing property. So selling your home for what you perceive to be less than full value can feel much worse than getting another home cheap. A rational individual might decide to sell their current home for less if they got the chance to buy another home for an even bigger discount. But in real life, the psychological cost of selling your current home for less than you want is often greater than the benefit of getting another home for a lot less than you might otherwise have paid.
There are other factors at play here, not least the fear that you might not find a more heavily discounted house once you had sold you current home. But the endowment effect is an important and unseen influence that explains why a lot of owners have not taken the opportunity to sell quickly and trade up to another home offering a bigger discount on its previous value.
Secondly, loss aversion means that we don’t like the idea of selling our home for less than what it was once worth. That is true not just for those who don’t want to, or can’t for mortgage reasons, sell for less than the purchase price, but also for those who know what their home was worth earlier in the market cycle.
Even if we bought our home years ago and its current value is well above what we paid, we are reluctant to lose some of the value that it achieved at the peak of the market. We are hard wired to hold on and wait until prices recover, even it would actually make sense to sell now and realise a considerable gain.
You can see the effects of these forces on the market every day. There may be lower demand from buyers than was the case before the credit crunch, largely as a result of restricted mortgage availability.
But on the other side of the coin, the fall in demand has been matched by a fall in supply as would-be sellers decide to stay put. The Endowment Effect and Loss Aversion are key (but not the only) drivers of this trend, making us reluctant to sell for less than we think our home is worth or for less than it was once worth. Both of these forces have been ably assisted by exceptionally low interest rates that have made it easier for many owners to stay put if they want to.
The sharp decline in the number of homes coming on to the market has helped to match supply to demand and so supported prices. That has achieved some sort of equilibrium at very low transaction levels.
But there is an unrecognised cost to those who would really like to move and don’t because the selling price might be lower than their valuation of their home. Staying put means that they are not free to take up opportunities that would offer even greater rewards if they were grasped.