housing investment and money illusion

Housing over the long run has not been a good investment. In the United States, for example, house prices have barely kept up with inflation since World War II, so have been quite flat in real terms. Stock prices in contrast have quadrupled in real terms over the same period. Nonetheless, housing is widely perceived to be an attractive investment. Why?

Two young economists from the University of Vienna suggest that this reflects “an aversion to nominal losses”, and tolerance for real losses in the presence of nominal gains. The authors claim to have found a “new psychological explanation”, so avoid using an older term to describe this behaviour. The term is “money illusion”. Yale economist Irving Fisher (1867-1947) long ago wrote an entire book on the subject, with the titleĀ The Money Illusion (Adelphi, New York, 1928).

Many people view housing as an attractive investment with good potential, despite meagre real capital gains over the long run. We suggest nominal loss aversion as a psychological mechanism that can help to explain the surprising popularity of housing as an investment. Using data from a survey experiment, we find that evaluations of housing transactions are shaped by gaining or losing money. We find no evidence that property ownership reduces this bias, but do find strong evidence that more education and greater cognitive reflection do. These results suggest that better financial education may reduce this bias towards overinvesting in housing.

Thomas Alexander Stephens and Jean-Robert Tyran, “Why is housing such a popular investment? A new psychological explanation“, Vox, 23 November 2012.

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