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Busts in House Prices

To examine the risk of asset prices either for purposes of modeling or portfolio construction, many analysts use the variance of price returns as their risk measure. However, if the return distributions are fat tailed, the variance does not sufficiently reflect the real risk faced. Especially when comparing the returns on different assets, this may lead to false conclusions concerning their relative riskiness. In this paper, we examine the distributional characteristics of United States and Dutch house price returns and find that these are distributed with much fatter tails than a normal distribution. We then focus explicitly on this observed tail fatness and analyze the risk on house price indices and stock indices in terms of the probability on extreme events over different time horizons. Our results clearly indicate that the variance as a risk measure underestimates the real risk associated with house price movements and that risk due to extremes is persistent.