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The economic coin toss                                                                                    

Posted at: Mar/04/2011 : Posted by: mel

Related Category: Economics,

It's been almost five years since the housing bubble popped. When the housing market evaporated venture capital and the creation of new businesses seemed to also disappear. Just with respect to the housing market the ever repeating question has been “why is it taking so long for the housing market to sort itself out?” I have read theories and heard congressional hearing talking about the glut of short sales, lack of money supply, a soft job market, etc… All these are the normal things we expect economist to speak of when the microphone is on and they are justifying their expensive PHD from some Ivy League school. Fact is, the Alan Greenspans and Ben Bernankes of the world love using their special language to prognosticate. I am sure their words are meaningful; they just don’t seem to mean anything to me. Recently I came upon a new theory for explaining the stalled housing market recovery and the general economy that is one of those epiphanies that exemplify beauty in simplicity.

The answer is as simple as a coin toss and comes from Professor Eric Johnson of Columbia’s Business School. He offers a simple bet on the flip of a coin. If the coin comes up heads, I would win $6. If it came up tails, I would lose $1. Obviously, that is a bet I would take and so would virtually everyone surveyed. But then he changes the terms of the bet; if the coin comes up heads I would still win $6. If it came up tails, I would lose $4. I don’t know about you, but I can’t really afford that bet and I would decline. As it happens, the majority of the people surveyed also said they would decline this bet. Of course, mathematically this is irrational. The bet is still very much in my favor. If I flipped the coin for the bet 1,000 times, I'd almost certainly make a nice profit.

I was intrigued enough by the psychology of the test I tried it on a co-worker who races dirt bikes in the desert as a hobby (sounds like a risk taker). Following Professor Johnson’s model I told him I'd pay him $15 if he won, and he'd only have to pay me $10 if he lost. His response was “no thanks.” The fact that the potential gain outweighed the loss did not matter to him. When I asked him why; he was very clear that he simply “couldn't afford to risk losing $10.00.” Actually, I was kind of glad because in all honesty I can’t afford to throw around $15.00.

As it turns out, the majority of people surveyed also turned down the bet.

There is apparently a lot of research indicating our brains feel losses and gains unevenly: Losing feels worse than winning feels good. For many folks who live marginally, with little money to spare, the extra $15 will make their lives $15 better, but the $10 has real consequences (say bouncing a check, missing a car payment, etc) beyond a simple balance sheet line item of loss or gain. Tomorrow I might be willing to take the bet, but there have been many days in my life where I would rationally have turned you down, as the consequences of going hungry for a day are much worse than the joy of eating better for a couple days. (i.e. on the fringe money is highly non-linear which is a concept most economist fail to grasp when talking in their special speak).

This little discussion pertains to the economy so it is time to make my little coin toss tangent meaningful.

In a down market, people really don't want to sell their homes because selling feels like losing. Let's compare two nearly identical homes where the owners of both have even managed that dream event of paying off their mortgages. Unfortunately, one had bought his home at the peak of the market. That person is likely to stubbornly ask for a higher price, and keep his home on the market longer than the other person, who had bought at a lower price. This is based on actual data from the housing bubble of the late 1980’s when the market collapsed in response to the failure of many Savings and Loans. So even when the mortgage is paid off, the home owner stubbornly wants to minimize their perceived loss and related risk.

When multiplied across potentially millions of home owners the overall magnitude of this effect is very big. There is no doubt that there are a lot of factors that influence the housing market including money supply, personal income levels, inventory glut, upside down mortgages. Never the less, we need to consider this psychological quirk when questioning how slow the healing process appears. It makes people reluctant to lower the asking price on their homes, which in turn contributes to the glut of houses on the market.

In the same respect, some people are looking at buying a house, and thinking, "What if I pay $250,000 for this house today, and tomorrow, a better one comes up for a lower price?" The fear of it keeps them from buying at all. More houses on the market and more people afraid of just when the perfect time to buy or sell is, when there really is no such thing as the perfect time.

Another variation on this theme is how we value different flavors of money with almost total disregard for the source. If we have $100 that we worked hard to earn, we spend it on the things that are most important to us. If we win $100, we spend it on the things that weren't important enough to buy with the first $100. In other words what we have to give up when we lose is more important to us than what we have to gain from winning. I remember as a kid that the money I received as a birthday gift generally got spent in frivolous ways, but the money I earned mowing lawns went to things I still have and value 35 years later.

There is a “Vegas” version of this same coin toss. Let's flip a coin. If you win, I'll pay you ten times your current net worth. If you lose, you lose your entire net worth. Want to play? Not surprisingly, most people don't. Even though they stand to make a lot of money most of the time, the cost of losing is far too high. Gamblers call this "risk of ruin".

There are a few people who are wired differently. I have a friend who had a business idea and took out 3 high interest mortgages on his home to bankroll his idea. He is now very wealthy. There is something uniquely different about people like my friend. I would never have been able to take that kind of risk with a family to feed and shelter, but that doesn’t make my friend irrational, just special. It is special people like this who regardless of an up economy or a down economy make leaps the rest of us can’t. While some of these leaps fail, some succeed creating innovation, new business, new wealth and lots of jobs. We need these risk takers even if they make no sense; they’re the ones who actually drive an economic recovery.

I would love to be like my friend, but I am wired the way I am wired. Financial risk, whether a home or business for me is all about the “sleep coefficient”. If I lie awake at night worrying about my business decision, level of debt, car purchase or mortgage…then they are not the right fit for me. My level of risk has to allow me to sleep at night, maybe that is why in my few and far between trips to Las Vegas all I ever take is a roll of quarters.

In researching this I have learned a lot without actually answering definitively any questions. It is clear that individually, the way each of us handles risk is almost hardwired. It is also clear that for the majority of us we overemphasize losses. It still fascinates me to watch almost with envy those who can take the big risks and thereby reap the rewards of the big gains. As for the rest of us, Professor Johnson says it could go back millions of years, to when a losing bet was way more serious.

Many thousands of years ago, we were avoiding animals that wanted to eat us. Today, we're just trying to protect our money.

Risk, reward or ruin, even if it is nothing more than just a coin toss, I’m not gambling what I can’t afford to lose. I don’t think it is at all irrational, that some part of our brain may be still be thinking about leopards chasing us into the trees.

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