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the long view

Stephen Poloz has done a novel thing for a central banker. He's bluntly told most Canadians that their most valuable asset is worth far less than they think it is.

When the Governor of the Bank of Canada presented research last week arguing that Canadian homes are 10- to 30-per-cent overvalued, it was a stunning departure from the usual see-no-evil, market-knows-best boilerplate preferred by the heavy hitters in monetary policy. Alan Greenspan, the former U.S. Federal Reserve chairman, was the last major central banker to step out of character when he dared to suggest back in 1996 that there might be a wisp of "irrational exuberance" behind the dot-com frenzy. For that, he was widely mocked. Lesson learned: When the United States embarked on its own epic housing craze, Mr. Greenspan reverted to type and remained resolutely inscrutable.

Mr. Poloz, in contrast, is willing to make his misgivings clear. But now that he has taken the brave and unconventional step of acknowledging an overvalued market, a big question looms: Will Canadians actually listen?

The answer hinges on coffee mugs – or more precisely, how we view coffee mugs and everything else we own.

One of the most famous experiments in behavioural finance offered people a chance to buy and sell mugs. The experimenters – future Nobel prize winner Daniel Kahneman, Richard Thaler and Jack Knetsch – found that people demanded twice as much money to sell a mug they already possessed compared to what they were willing to pay for a mug that belonged to someone else.

The disparity between the two prices is said to reflect an "endowment effect." In essence, we put a much higher value on things we already own than on things we don't.

Anyone who's watched a friend or relative try to sell a house in a down market has witnessed the endowment effect in operation. People have a strong tendency to stick to their initial asking price even if no one shows interest. There's always some reason – that lovingly restored toolshed! – the remarkable view of the town bog! – to make owners think their house is worth more than the market says it is.

The endowment effect suggests that we shouldn't expect to see home prices immediately follow Mr. Poloz's pointer and slide back to more rational levels. In fact, Mr. Poloz and his team say the risk of any large fall in house prices over the next couple of years is relatively small.

But that doesn't mean that Canadians should disregard the warning. Mr. Poloz may be playing a central banker's game – pointing out a danger as strongly as he can while trying not to spark panic. The fact that his messages about home prices are becoming increasingly explicit suggests his level of concern could be even higher than his public pronouncements.

The Bank of Canada research unveiled last week uses a complex economic model to come to the same conclusion that many researchers have arrived at using simpler reasoning. The simple logic goes like this: Up until 2000, Canadians paid about three times their annual incomes for houses; now it's more like five times. Even if you assume that some part of that increase is the result of real changes – perhaps tighter zoning restrictions or increased numbers of foreign investors – home prices seem poised to take a nasty hit if the relationship between real estate and incomes begins to revert to its historical level.

The effect on our bottom lines would be painful. In 2012, real estate accounted for more than three quarters of the typical household's wealth, according to a report by Environics Analytics. A 30-per-cent fall in home values would lop off more than a fifth of Canadians' net worth.

You can, of course, brush off such threats. Economic forecasts, after all, are only slightly more reliable than the guy who wants to sell you a list of surefire winners for next week's NFL games. But at the very least you should make sure that your retirement plan incorporates the chance that your home will be worth less when it comes time to sell than it is now.

One other simple idea: When figuring out how much you're paying on your mortgage, mentally add a couple of percentage points to the annual rate to reflect the possibility that your home will lose 20 per cent in value over the next 10 years. If your spouse asks you why, tell him or her that your friend Steve in Ottawa suggested it.

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