Bank of Canada Working Paper - Credit Conditions and Consumption, House Prices and Debt: What Makes Canada Different?

"High and rising real house prices in Canada since the late 1990s can be mostly explained by long-run movements in incomes, housing supply, mortgage interest rates and credit conditions. This implies that the outlook for house prices depends largely on the future paths of these variables. For example, mortgage rates will at some point rise from historically low levels. All else being equal, and under certain assumptions, our model suggests that a 100 basis point rise in mortgage rates from, say, 2.5 to 3.5 per cent would decrease real house prices by about 12 per cent over the subsequent 5 years. It is difficult to be overly precise about these estimates and, in practice, higher mortgage rates could be correlated with stronger incomes that could provide some partially offsetting support for house prices. These aspects would need to be taken into account in a more refined projection."

http://www.bankofcanada.ca/wp-content/uploads/2015/11/wp2015-40.pdf

Who to listen to

I don't know. But I do know that Paul Krugman was recently rated as the "top prognosticator" by a recent Hamilton University analytical survey (PDF).

The Hamilton students sampled the predictions of 26 individuals who wrote columns in major print media and who appeared on the three major Sunday news shows – Face the Nation, Meet the Press, and This Week – and evaluated the accuracy of 472 predictions made during the 16-month period. They used a scale of 1 to 5 (1 being “will not happen, 5 being “will absolutely happen”) to rate the accuracy of each, and then divided them into three categories: The Good, The Bad, and The Ugly...

The top prognosticators – led by New York Times columnist Paul Krugman – scored above five points and were labeled “Good,” while those scoring between zero and five were “Bad.” Anyone scoring less than zero (which was possible because prognosticators lost points for inaccurate predictions) were put into “The Ugly” category. Syndicated columnist Cal Thomas came up short and scored the lowest of the 26.

Take the survey for what it's worth, but Krugman recently highlighted the dangers of over-leverage, namely it being a harbinger of subsequent financial problems:

When I wrote the first edition of The Return of Depression Economics, I was reacting in large part to the Asian financial crisis, which I thought could presage similarly difficult crises here in America. Sadly, I was right.

But what made Asia so vulnerable then but not so vulnerable now? Even then, the best available stories ... focused on issues of balance sheets and leverage. And it’s now standard to focus on household leverage as a key part of what went wrong in 2008:

[end quote]

Now if we put this measure beside the equivalent Canadian measure it looks all the more interesting (courtesy theeconomyanalyst.com):

Looking at disposable income isn't quite an apples-apples comparison due to Canada's greater contribution to social services like education and health care. Also the normalization of the scales can add in some debate over the relative peaks. Insofar as the debt-to-disposable-income ratio was brought forward before the GFC by Krugman, a pundit with a proven track record, and comparing the order of magnitude of debts Canadian households are currently carrying, irrespective of some tax policy differences, it should give policymakers some food for thought in the coming year.

Bank of Canada Paper on Housing Stock

Title	A Model of Housing Stock for Canada
Author	David Dupuis and Yi Zheng
Type	Working Paper 2010-19
Date of publication	July 2010
Language	English
Abstract	Using an error-correction model (ECM) framework, the authors attempt to quantify the degree of disequilibrium in Canadian housing stock over the period 1961–2008 for the national aggregate and over 1981–2008 for the provinces. They find that, based on quarterly data, the level of housing stock in the long run is associated with population, real per capita disposable income, and real house prices. Population growth (net migration, particularly for the western provinces) is also an important determinant of the short-run dynamics of housing stock, after controlling for serial correlation in the dependent variable. Real mortgage rates, consumer confidence, and a number of other variables identified in the literature are found to play a small role in the short run. The authors’ model suggests that the Canadian housing stock was 2 per cent above its equilibrium level at the end of 2008. There was likely overbuilding, to varying degrees, in Saskatchewan, New Brunswick, British Columbia, Ontario, and Quebec.
Bank topic index	Domestic demand and components
JEL classification	E21, J00

You may download the paper in the following format(s):

• Acrobat (.pdf, 294 kb)

NBR | Behavioral Finance Basics | Your Mind and Your Money |

Yes, it is true. Our brains aren't always purely rational.

For example, paying more than the equivalent cost of rent to purchase a primary residence.

Or perhaps buying an 'investment' property that has a capital yield of a government bond, with a risk profile like a stock and the potential to bankrupt the owner because of the leverage involved.

Behavioural Finance - Effects on Housing

This is a decent background read on the implications of various studies on the housing market.

http://www.prres.net/papers/Kishore_Behavioural_Finance_Application_Property_Market.pdf

A Meaty Read

The Bank of Canada produces some great analysis that I read from time to time. This paper was quite interesting.

A quote:

From an aggregate perspective there are a number of reasons to think that house prices

could ináuence consumption decisions in Canada. First, residential structures and land

account for a large share of Canadian household sector wealth. Sixty eight per cent of

Canadian households own a home and for many it represents their largest asset. Second,

house price growth is associated with higher household borrowing. The positive correlation

between consumption and house prices may be related to housingís role as collateral. Between

2000 and 2007 the real price of existing homes increased by 52 per cent. At the same time,

the ratio of household debt to GDP rose dramatically from 58 per cent in 2000 to 76 percent

in 2007. By 2007 roughly 80 per cent of Canadian household debt was secured by real estate.

Sauder Housing Predictions

In a previous post I outlined basic theory behind net present value (NPV) calculations as it pertains to real estate and related it to a working paper (PDF) published by Dr. Somerville and Kitson Swann at the Sauder School of Business at UBC. I have read a few online discussions popping up recently regarding this paper, brought on I am sure in part by Dr. Somerville’s many recent quotations in the local media.

The paper claims that Vancouver’s house prices would need to drop 11%, from a benchmark of $754,500, to return to “equilibrium”: $680,000. If we look into the methodology used in the paper, the cost of capital elements such as tax, depreciation, and maintenance are determined by a percentage of current house value. This is fine however, should the house value change, we must re-adjust the figures as I will now do.

The cost of capital was calculated to be, as percentages of the original price: maintenance and insurance 0.5%, depreciation 1.07%, and tax 0.5%. All of course are fixed costs that will not vary significantly with changes in land value so nominally these values are $3773, $8073, and $3773 respectively. Note the $8073 number for depreciation is way too high and should be around $2500-3000 but for now let’s leave it as is.

The REBGV just released their statistics showing the new benchmark price in Vancouver is about $696,000 so let’s re-calculate the cost of capital, assuming as before a 5.4% annual capital appreciation (which I will deal with in a bit). The new percentages are: maintenance and insurance 0.54%, depreciation 1.16%, and taxes 0.54%. The new equilibrium cost of capital is 4.27%.

Uh oh. Now we need to re-calculate a new equilibrium price with the new cost of capital. Plugging in the numbers we get a new “equilibrium” value of $652,000. That is a drop of -13.5% from the paper’s benchmark price and a further -6.3% from today’s market price. If we perpetually plug in the new “equilibrium” prices into the formula, as we now must given prices are dropping fast, the new “equilibrium” converges at $602,000. Put another way, the true “equilibrium” price, given the property’s nominal costs and expected capital appreciation, is -13.5% below today’s benchmark price and -20% below the number used in Somerville et al’s paper.

It unfortunately does not stop there. I must take exception with the purported 5.4% annual appreciation numbers cited as the long term expected average appreciation in Vancouver. While this may have been true in the past there are at least three good reasons to believe this level of appreciation is far too optimistic.

The first way that prices appreciate is by rising incomes however Vancouver’s real incomes are flat. This means that in terms of long-term affordability, dwelling prices cannot increase much faster than incomes are rising, roughly at the rate of inflation. There is little in the short term to believe that incomes will be rising faster than inflation; in aggregate with falling employment and a looming recession the opposite is far more likely to happen in the medium term.

The second way prices appreciate is by densification; that is, the anticipation of using a piece of land to produce higher future incomes. Here there is a good argument that some property prices can appreciate faster than incomes are rising if they have not fully densified yet. However some quick deduction can show that there is a limit as to how fast average densification can occur: the population growth rate (around 1.2% in Vancouver area). From a practical perspective the actual densification will occur less because new land (farmland and forest) is being turned into residential dwellings, easing the maximum densification potential.

The third, and the most striking, way prices appreciate is through a waning of inflation expectations that has resulted in perpetually lower mortgage rates over the past generation and this has, through a perpetually decreasing cost of capital, caused unusually high capital appreciation. We are at a point where inflation expectations are unlikely to decrease much more. The best scenario is for mortgage rates to stay flat; the worst is for them to increase.

Taken all three together, the maximum nominal appreciation I would expect from Vancouver detached housing going forward is around 2.5-3% annually. Condos, due to the fact there is little possibility of densifying further, will likely appreciate at inflation, say, 2%.

Coming full circle, using my newly expected capital appreciation estimates, we can further adjust the cost of capital up by 2.4% and re-calculate “equilibrium” value. Astonishingly the new price drops to $270,000. Note this is too low, mostly because the depreciation number used in the paper is too aggressive. Using a more realistic annual building depreciation of $2500 we can re-calculate “equilibrium” at approximately $400,000. You can make other assumptions – perhaps a lower mortgage rate – and arrive at equilibrium a bit higher, however it will be difficult to justify anything but a significantly reduced outlook for the long-term appreciation of property prices compared to Somerville et al’s estimates.

Edit: Commenters here and in other places in the local RE blogosphere have raised questions about depreciation as a line item in a DCF (discounted cash flows) calculation. While I agree depreciation is not a cash flow, in this case depreciation represents an expected decrease in future cash flows below headline estimates. In terms of the formula's framework, for what it is, depreciation does account for decreased future cash flows but is not explicit enough to really know what Somerville is modelling. Read the comments for an alternate approach.

Also the "densification premium" awarded to detached properties is further reduced when one accounts for capital costs associated with making land more productive. More bad news.

Canada faces housing bust: Shiller

Jacqueline Thorpe, Financial Post Published: Wednesday, October 01, 2008

The Canadian housing market could face a similar housing bust to the United States, particularly in more bubbly markets as Vancouver and Calgary, said Robert Shiller, the University of Yale professor who predicted both the 1990s stock market boom and bust and the US housing slump.

Mr. Shiller, co-founder of the S&P Case/Shiller Home Price Index, said psychology is the primary driver of bubbles and it appears that Canada has been caught up with home buying fever just as the United States and other countries around the world.

Asked whether that meant Canada could face a similar bust Mr. Shiller said: "Yes, especially in places that went up a lot like Vancouver and Calgary. I don't think Toronto has been quite as extreme."

Mr. Shiller said there was a natural connection between the United States and Canada.

"I would be surprised that the bubble that appeared in the United States and elsewhere didn't appear in Canada," he said in an interview with the Financial Post. "It's psychology, I think that drives it.

Mr. Shiller, whose book Irrational Exuberance came out in March 2000 just as the tech bubble peaked, said it was essential for the U.S. government to pass a financial bailout, though he believes the United States is facing a "severe recession," regardless.

"I'm concerned problems are deeper than can be handled by the bailout but that doesn't mean the bailout doesn't do some good," he said.

He said a bailout might help restore some confidence to the stressed financial system.

"What creates a crisis is a lack of confidence," he said.

He said the housing crisis was primarily a policy failure by U.S. authorities.

The U.S. government was "totally blind" to it, regulators failed to monitor the mortgage industry properly and the U.S. Federal Reserve had very low interest rates at a time of the greatest housing bubble of all time.

While homeowners should take some personal responsibility for the debacle, they were being goaded into the fevour by an establishment that endlessly pushed an ownership society.

"They were doing what was considered right at the time," Mr. Shiller said.

Mr. Shiller said human nature seems to predispose people to spectacular excess, fanned by a voracious news media.

"Until we had newsapers and other media we had no bublbles, he said.

While ups and downs in the market can lead to creative destruction the current housing crisis has morphed into a system problem.

"The problem is that perfectly good firms are in trouble," he told the Financial Post in an interview at the Ontario Economic Summit.

A bailout may not be palatable, government assistance is required when the system fails.

The trick is to reduce conditions that fan bubbles.

In his current book, "The Subprime Solution," Mr. Shiller proposes several measures to reduce bubble conditions in the housing market including better information for prospective buyers and broader markets that trade risk better, such as the housing futures he has developed on the Chicago Mercantile Exchange.

There should also be new retail products such as "continuous workout mortgages," that go up and down with the value of the home equity and mortgage equity insurance.

Mr. Shiller, who would not give a precise forecast on the outlook for U.S. home prices, nevertheless said futures markets are predicting more price declines of 10% or more. His Case/Shiller index earlier this week showed home prices down 16.3% year-over-year this summer.

He expects things to get worse for the U.S. economy in the short-term.

"We're going to have a severe recession, most likely," he said. How quickly the economy recovers depends on policy.

"Unfortunately the bailout has hit a snag," he said. "There is resentment of rich Wall Street people. I am worried that the sense of trust, in confidence of each other is being damaged."

Mr. Shiller said he does not have another bubble in his sights as the U.S. economy will be "damaged for years."

"The housing bubble was of record proportions," he said. "Maybe the next big bubble will be your children's or grandchildrens...The excitement we had in the 1990s and in 2000 in the housing market is a fragile thing and it won't come back for some time."

Phinance for Physicists #1

Thanks to jesse for putting this together and doing some legwork.

I had a brief email conversation with Dr. Somerville on his recent paper regarding proper valuations of residential houses in different Canadian cities. He and I agreed that the life of an economist involves a bit more than plugging numbers into equations. However economics is a science so, having no significant formal finance/economics training but a bit more physics training, I thought I would bridge the divide with some much touted but rarely practiced cross-disciplinary legwork. Scientist to scientist.

A good friend of mine opined about physics education that the number of lies told during one's schooling slowly decreases. In many ways, in my current view, economics is like this. We use simple formulas, supply-demand curves, etc. in an attempt to understand the world around us.

With my limited understanding of finance, here starteth the lies.

Net Present value

The concept of The Net Present Value (NPV for short) is determining fundamental value for an asset, such a car, a boat, a stock, a pair of droids, a sail barge, or a house. The concept is simple: that the purchasing of this asset ties up one's money that cannot be used for other things, that people generally want to maximize their wealth, and that there is risk in tying up money in an asset.

Rule#1: The Net Present Value (NPV) of an asset is the sum of a series of expected discounted future cash flows.

What it means is that rational investors, given all other available choices with what to do with their money (opportunity cost), the risks involved, the expected revenue, expenses, and a little something for their trouble, will look at an asset and determine what the maximum they would be willing to pay to produce a fair return.

We can derive a rough formula for the net present value of, say, a condominium that is rented out. We assume the condo is rented out forever, which is a reasonable approximation (forever and 30 years produce about the same number). Returns and inflation compound so the series of cash flows increases geometrically but are discounted:

(1)

where i is the expected inflation of rent and expenses (say, 2% per year), and r is the so-called discount rate that is a combination of the long term bond rate (that includes expected inflation), a risk premium, and depreciation. The discount rate is a method of combining risk, inflation, and opportunity cost into one number. Rent is gross annual rent, and Expenses are annual maintenance, tax, and insurance costs (et cetera). Financing costs are not included here as the decision to buy is based upon having cash in hand, though more advanced analysis can explicitly include them. (Financing costs are, to a degree, implicit in the above formula) Note depreciation could be abstracted in Expenses or as part of the discount rate r.

Note that some condos will have more problems with tenants than others. How this is handled in the calculation is typically by having a higher risk premium included in "r" though in essence it could also be handled by using the expected value of rent, not nominal rent. The same principle applies for expenses, like the probability and expense of a condo being leaky for example.

This is in fact the formula mohican used to calculate fundamental value. He chose to use r-i (also known as the "cap rate") as the 5 year mortgage rate as a rough approximation. In his words, "The bond market and the banks are particularly efficient at determining the risk premium and adequately price that in to the 5 year mortgage rate. This is why I use it." Mohican also clarified to me that he assumes land appreciation and structure depreciation are roughly equivalent. It's also worth noting that mohican has chosen to use a relatively simple formula to estimate fundamental price and not spend too much time in details. In general there is nothing wrong with this but in certain situations it helps to know what to do if there are significant deviations.

The working paper Dr. Somerville et al published uses a formula similar to this but in a different form. It can be derived from the same basic principle, resulting in:

(2)

Where k is the long term mortgage rate, t is tax rate, m is maintenance, d is depreciation, (the last 3 are as % of property value) and E(DP/P) is expected capital appreciation.

Without going into the details, both mohican's and Dr. Somerville et al's chosen formulas can be construed to have been derived from Equation 1 above, from a strict financial, not economic, perspective.

Example

Let us use mohican's chosen formula in a simple example. A condo rents for $1000 per month, just sold for $220,000 and has expenses that are 20% of rent. The mortgage rate is 6%. NPV = 1000*12*0.8/0.06 = $160,000. This means that a rational investor who is looking only at future cash flows will be willing to pay $160,000 for this condo, according to mohican's formula.

Now, let us use Dr. Somerville et al's chosen formula for the same condo. We will assume that this condo will "conservatively" appreciate at E(DP/P) = 3% per year, k is 6%, t is $1200/year, or 0.5%, m is 0.5%, and d is about 1%. According to this formula a rational investor will pay 12000/(0.06+0.005+0.005+0.01-0.03) = $240,000

Analysis

Why the difference? There are two reasons. The main reason is contained in E(DP/P). It turns out, according to first principle derivations, that E(DP/P) is equal to the expected appreciation of future cash flows. In other words, a value of E(DP/P) increasing faster than cash flows are increasing from the current asset is expecting to either sell the asset to someone in the future for a price inflated by E(DP/P) (selling an asset is a cash flow), or that cash flows can increase more sometime in the future by using the asset more productively. Assuming 3% annual appreciation is more than what was implicitly assumed by mohican.

The second difference is more subtle. Remember in Equation 2 the expense costs were as a percentage of value. If capital appreciation continually outpaces rent inflation, these percentages perpetually drop; in other words the cost of capital perpetually decreases. This works mathematically but one must realize that the capital appreciation inherently includes productivity increases above what the current structure can support. The potential flaw in this is that the expenses must include construction costs for the productivity enhancements and would boost the percentages higher than what was calculated. Furthermore, and more importantly, one must think hard about what value to use in the denominator of the percentages. For this reason it may (must) be preferable to pull m, t, and d and make them nominal, not as a % of an arbitrary pre-calculated value.

Remember Equation 1 assumes an infinite series of geometrically increasing cash flows. If at some point in the future rents increase faster than expected or the land can be further sub-divided and used to produce more rent (say turning a 5 story condo into a 20 story condo 15 years from now), the NPV could be higher than what current cash flows suggest. One can approximate this by adjusting upwards the exponent on the geometric series. Expenses, too, can be nonlinear if there are major renovations or redevelopments in the future. If, however, the cash flows spike up (or down) too far in the future, their present values are diminished so as not to significantly change the expected capital appreciation rate. For example 1000 years from now a giant space tower with 6000 floors is likely to be built in a detached residential neighbourhood. This will have close to no impact on NPV, even if it were a certainty.

We can of course solve for E(DP/P) to figure out, if the condo just sold for $220,000, what the rational investor expects for capital appreciation.

Another measure thrown around local blogs is the 100X-125X monthly rent multiplier for condos. This would put our example condo at $100,000-$125,000. There is historical precedent for this occurring, though just as prices can be above one's calculated NPV, they can drop below as well. It IS reasonably possible to calculate NPV equal to 100X rent in Vancouver; in fact I think there is a good chance of select condo sale prices equaling this someday soon.

Regardless of which formula, mohican's, Dr. Somerville's, or some other fundamental asset formula, you may choose to use, remember that their roots are the same but their assumptions can be different.

The next (lesser) lie to discuss is looking at E(DP/P) -- capital appreciation -- in more detail; naturally, with housing in mind of course.

How Thinking Costs You

Behavioral Economics Shows That When It Comes to Investing, People Aren't That Smart
By Michael S. Rosenwald, Washington Post Staff Writer, Sunday, May 25, 2008

Four months ago, judging myself to be the next Warren Buffett, I logged on to my Charles Schwab account and did something that in hindsight was astonishingly stupid, even for my own very long roster of financial screw-ups. I clicked over to the trading page and bought shares of Citigroup.

The company, like most of the big Wall Street banks then staring down the subprime meltdown, was limping along. The headlines were bad. The chatter on CNBC was pessimistic. I saw a bargain. I saw a company whose credit card bills and offers show up in millions of mailboxes every day. Just as soon as the banks got their write-offs out of the way, optimism would return to the sector. There would be more buyers of the stock than sellers. I would profit.

Now here I am today: My investment is down 22 percent. And I'm still holding on to the stock. Am I, as my wife and closest friends sometimes insist, the dumbest man walking the Earth?
"You are human," said Russell Fuller, chief investment officer of Fuller & Thaler Asset Management in San Mateo, Calif. His firm uses behavioral economic theories of Nobel Prize winners and university economists to profit from the mistakes made by everyday investors and the pros on Wall Street. Humans, no matter how hard we try, act in ways that cause us to make the wrong investment decisions almost all the time.

We are -- as I was four months ago when I logged on to my Schwab account -- absurdly overconfident about what we think we know. We are -- as I am now -- reluctant to part with our losers, even though the tax code rewards us for doing so. We sell winners too soon, then we buy stocks that perform worse than the ones we sold. We get anchored on certain opinions about stocks and react too slowly to information that should change those beliefs. We believe things will happen based on how easily we can think of recent examples. (A hurricane just hit. Another one will come soon.)

The world of the behavioral economics, which melds psychology, finance and emotion, seeks to explain and sometimes exploit why we do what we do when it comes to investing. It is a field that has become more accepted lately, particularly since 2002, when Princeton University psychologist Daniel Kahneman was awarded the Nobel Prize in Economics for, as the Swedes put it, integrating "insights from psychology into economics, thereby laying the foundation for a new field of research."

Kahneman is a director at Fuller & Thaler, a firm whose other namesake is Richard Thaler, a prominent University of Chicago behavioral economist and a frequent collaborator with Kahneman. Two of the funds the firm manages that use behavioral methods have beaten Russell benchmarks from their inception through the first quarter of this year. Not surprisingly, Fuller & Thaler is not the only firm using such techniques. Firms ranging from J.P. Morgan to AllianceBernstein say they seek to capitalize on the faulty investor mind.

For instance, Fuller & Thaler likes to pay close attention to analysts who may be anchored on a stock, not raising their earnings-per-share estimates enough even though positive information has come out about the company. Fuller & Thaler's investment team pounces before the analysts realize they were wrong. As Kahneman said in an interview, "I think that betting on mistakes of people is a pretty safe bet."

Good for them. My interest in talking to the likes of Kahneman, Thaler and other behavioral economists and personal finance advisers -- besides confirming that I am not dumb -- was to understand these mistakes and what there is to do about them. "I don't think you can fix what's in your head," Thaler said. "What you can do is train yourself to say, 'This is a risky situation, and this is the kind of situation where I get fooled.' "

I asked Kahneman what fools us most frequently. That was simple, he said: overconfidence. "It's the idea that you know better than the market, which is a very strange idea," he said. "Individual investors have no business at all thinking they can do better."

Why do we? "It's because we have no way of thinking properly about what we don't know," Kahneman said. "What we do is we give weight to what we know and then we add a margin of uncertainty. You act on what you think will happen." That's what I did by buying Citigroup. But Kahneman added, "In fact, in most situations what you don't know is so overwhelmingly more important than what you do know that you have no business acting on what you know." Oops.
Barbara Warner, a financial planner with Warner Financial in Bethesda, said she sees a lot of overconfidence among two groups of people: relatively new investors to the market (me), particularly recent business school graduates (not me), and retirees (never, with my investment sense). The latter group can be exceptionally frustrating. "Now they have entirely too much time on their hands to devote to CNBC and Money magazine," she said. "People suddenly think they are smarter than they used to be because they have more time to pay attention to it."

That's a disastrous situation, Kahneman said: "The more closely you pay attention, the more you do things. And the more you do things, the worse off you will be." For proof, he pointed to groundbreaking research done by one of his former students, Terrance Odean, now a professor at the University of California at Berkeley. Odean has written that "overconfidence gives investors the courage of their misguided convictions."

He has gathered trading records from discount brokerage houses for hundreds of thousands of investors, and in several published studies, he has shown that when people had a choice of two stocks to sell, more often than not they sold the stock that did better in the future and held on to the one that did worse. And when they bought something new, they tended to buy a stock that did worse than the stock they just sold. As Kahneman once told Odean, "It is expensive for these people to have ideas."

It is particularly curious when investors hold on to losing stocks, as I have done with Citigroup. This is a function of something called loss aversion, a discovery that helped Kahneman win the Nobel Prize. Thaler, Kahneman's close colleague, put it this way: "Loss aversion refers to the fact that we're wired in such a way that losing money hurts more than getting money feels good." So let's say a hundred bucks falls out of my wallet, lost forever. Under loss aversion, this hurts a lot more than it feels good to find $100 that somebody else lost.

When it comes to trading, this helps explain why we would want to hold on to losers. Selling the loser, even though it gives us a tax write-off, causes us to admit we have lost. So we do something that makes us feel better: We sell the winners. This feeds our overconfidence. But as Odean's research has shown, we often sell winners that still have some winning to do. That puts stocks with upward momentum on the market for less than they are really worth long-term, allowing savvier investors to snap them up.

"What I believe is that individual investors probably as a group create the dynamics by which they lose money and institutions make money," Odean said. "They create mispricings."
Along with several co-authors , he has published a somewhat depressing study about just how much wealth can be lost by everyday investors just because they trade. Looking at data from every trade made by all investors in Taiwan from 1995 to 1999, Odean discovered that the "aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points," which includes trading costs. If investors had simply bought the index and not traded at all, they would have done about 3.5 percent better. The amount of money lost was equivalent to 2.2 percent of Taiwan's gross domestic product.

So what should mere humans do about all of this?

Like most things human, it depends on which one you ask. Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market. Kahneman said there was no one-size-fits-all advice, but he liked the idea of having one sure thing and one long shot. The personal finance planners say investors should stick with them -- they get paid to understand this stuff, and to win. Of course, they are humans too, which means they could be prone to the same problematic behaviors.

As for me, I'm taking some responsibility for myself, which is probably where everyone should start. Earlier this week, I logged in to my Schwab account. I sold my Citigroup shares, at a loss. I'm going to push the money into an index fund. The move felt bad, no doubt about it. I didn't fix what was in my head, but I did fix what my head had done.

Fama and French Speak

Watch this interview with Eugene Fama. http://www.dfacanada.com/library/videos/thinkers_fama/

Watch this interview with Kenneth French.
http://www.dfacanada.com/library/videos/thinkers_french/

Enlightening.