On October 12, 2007, American investors celebrated a new high-water mark as the Dow Jones Industrial Average hit an all-time high of 14,093. Stocks were booming, and many people were buying. Home values had also increased substantially over the previous decade, producing substantial wealth for those who had invested in home ownership. Many had taken out large loans to buy up real estate as an investment, counting on continuing increases in home prices to produce value. With a large cohort of baby boomers preparing for retirement, many had built substantial wealth through stock and real estate investments and felt well prepared financially for a long and comfortable retirement. That’s when things started to go sour.
Housing prices had begun to decline slightly between August and October, but by November the decline in home values had become too much for investors to ignore. Stock prices started a slow decline also. Although most prognosticators clearly predicted that further losses in real estate and stocks were ahead, optimistic investors began to reason among themselves, “I can’t get out now, I will lose money.” Sentiments such as “I don’t want to sell at a loss. I will wait until the price goes back up to where I purchased, and then get out,” were common. In January 2008, real estate prices started a steep decline. Many homes were now valued at less than the outstanding debt on the mortgage. Those who had counted on the money they could make upon selling their property to cover the mortgage would now be forced to default. Banks that had made these loans were in trouble. After a short period of stability, the housing market went into a steep decline, losing almost 30 percent between August 2008 and February 2009. The stock market took notice. By October 2008, stock prices began to crash, losing as much as 18 percent in a single day. Investors were finally ready to sell even at a loss. By March 2009, the Dow Jones Industrial Average was only 6,627. Stocks had shed nearly 53 percent of their value. Massive amounts of wealth had been destroyed, and baby boomers were left to come to grips with the fact that they might have to put off retirement for several years and perhaps cut back on their planned expenses.
Often the plan to buy low and sell high doesn’t quite work out that way. Why are investors so willing to hold on to a losing investment when it becomes clear it will not perform? Although few would consider making new investments in what appears to be a losing investment, many are loath to shed losing investments if it means realizing a loss. Loss aversion has profound effects on the way decision makers deal with risky decisions. In many ways, the introduction of loss aversion to the economics of risky choice has been the cornerstone of behavioral economics. In 1979, Daniel Kahneman and Amos Tversky introduced a model of risky choice based on loss aversion, which they called prospect theory. For many economists, prospect theory was their first exposure to behavioral models. Prospect theory makes powerful predictions regarding behavior under risk, providing some of the most compelling evidence of behavioral biases in economic choice.