Loss Aversion

Felix Salmon has a rather interesting blog post about loss aversion and sovereign investors:

Much has been written on the behavioral economics of loss aversion, where the pain of losing a certain amount of money is nearly always greater than the pleasure of gaining an identical amount. And what’s true of a country’s citizens is often true of its government, which is why the question of whether or not governments are making a profit on their bank bailouts is an interesting and important one.

He continues:

But the point is that if Treasury continues to speculate now, it’s mere speculation. When it was underwater on its investment, it at least could say that it was holding on to its stake until the share price rose enough that it could get its money back. Yes, that’s a form of speculation too. But it’s somehow a more acceptable form of speculation to hold onto an investment in the hope that you won’t lose money than it is to hold onto a profitable investment in the hope that you’ll make even more money.

Indeed, the whole argument about whether or not banks should mark their assets to market is at heart an argument about this very question. If banks hold loans on their books at par, even if they could never get 100 cents on the dollar for those loans in the secondary market, they’re essentially speculating that the value of the loans will return, over time, to more than they lent out in the first place. But they don’t call it speculation, they call it “commitment to our valued clients through thick and thin”, or something like that.

This is all very interesting, and I think Felix (and the behavioral economists) are correct when they say that the pain of a loss exceeds the pleasure of a gain. At least, intuition suggests that that is how man thinks. But, this makes me wonder: if man is so averse to losses, why is there such a clamor for short sales and mortgage cram-downs? Those are nothing if not recognition of losses made on a crappy investment.

A side question about real estate: Given that debt-financed assets lose value as interest rates increase, and most residential real estate is financed with debt, why do people claim that real estate is an inflation hedge? The likely answer is that most people who acquire real estate don’t really know what they’re buying and don’t understand its underlying economics.

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