Monday, June 27, 2005

The Limits of Arbitrage

One key insight from the Behavioral school of economics is that arbitrage, that powerful force which eliminates all free lunches, is quite limited in practise. For example, suppose you felt was overvalued in 1999. To try to capitalize on that bet, you would have 1) had to short the stock (easy), and 2) made the margin calls as it doubled between 99-2000, and 3) hung on until it reached its nadir in 2002. Tricky stuff.

Similarly, Bryan Caplan wonders how one would arbitrage the current bubble in real estate prices.
But that gets me thinking. What would I actually do if I knew for sure that my house was going to plummet in value one year from today? My ideal solution would be to sell my house to someone, rent it from them for a year, then buy it back. But that would be very hard to arrange. In practice, I'd have to sell, rent whatever's available for a year, then use my nest egg to buy a comparable (or better home), pocketing the difference.
I suppose one could take out a large, fixed, reverse mortgage against the house -- essentially selling it to the bank and renting it back from them, but I'm not sure how you would unwind the position after prices decreased.

If you are a renter the answer is easy -- continue to rent while renting is so cheap.

Finally, I don't buy the argument that population explains the housing bubble. The population of Massachusetts *shrunk* last year, but housing appreciate in Boston is the highest in the nation.


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