By: Flabia Maharjan
House Money Effect
The concept of house money effect emerged from casinos where people continued gambling from the house money after making significant gains. It was later developed by Richard Thaler and Eric Johnson in their work, “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice”.
Playing with house money generally implies the willingness to gamble more with the winnings from the casino (the house) than the money from one’s pocket. Thus, House Money Effect describes how people undertake greater risks with money they haven’t worked hard for. It depicts the tendency to value unanticipated gains/windfall differently from the rest of their wealth.
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House Money Effect In Investment
1) Do Investors Dispose of Profits Recklessly?
House Money Effect is common amongst investors such that they take greater risks while reinvesting their profits than they would have while investing their initial capital. Since investors tend to consider capital gains distinct from their wealth, they spend it more recklessly. It means they assume gains to be more disposable than the money from their pocket. So, investors take risks in their following investments which they would have generally avoided, causing future gains to blow away.
2) Increased Risk Appetite
The risk appetite of investors significantly depends upon the profits or losses on their previous investment. Large and unanticipated gains increase the risk appetite of an investor resulting in higher risk-taking on the returns from the preceding investment. For instance, if an investor made a short-term profit from Stock A with a beta of 0.5, they would not hesitate to go for Stock B with a beta of 1.5 on their next trade. (Beta is a good indicator of stock volatility and risk: Greater the beta, the higher is the risk involved.) Therefore, the risk tolerance has significantly risen due to the success received on trading Stock A. It boosts the investor’s confidence to take on higher risks with the expectations of higher returns. But higher risk could lead to subsequent losses as well.
3) Mental Accounting Vs. Rational Accounting
House Money Effect is a result of mental accounting, which is the exact opposite of rational accounting. Mental accounting is a concept in behavioral economics that states that humans place different values on money, which leads to irrational decision-making. An investor who has made money on their previous trade is willing to take excess risk while reinvesting because the loss incurred will be treated as a reduction in gains and not an actual loss. Psychologically, it is less damaging for the investor as gains are assumed to be windfalls rather than one’s capital. However, an investor who faces losses without prior gains derives a greater disutility as it is treated as a loss of capital.
How to Overcome the House Money Effect ?
a) No Matter the Source, Treat Money the Same
Whether it’s money you earned doing hard labor or that you earned through investing in the stock market, it is your money, which demands you to use both in the same way. Returns from the stock market shouldn’t be treated differently from your hard-earned wealth. The profit you’ve gained is a result of your patience (for having waited for months or years). So, it should never be regarded as house money and therefore gambled.
As an investor, your risk tolerance shouldn’t alter depending upon the source of the money. The thought of selecting low to moderate risk stocks with your initial investment while going for high-risk stocks with the profits made from the initial investment is wrong. So, avoid taking higher risks with the returns from the stock market. If you’ve chosen a stock solely based on the money you’ve made on your previous trade, you are being irrational and do not value this investment as much as you would have ordinarily. Hence, avoid investing in such stocks. It is because you will end up regarding the losses (if incurred) as a reduction in gains and not a loss of capital, deriving lower disutility from it.
b) Letting Winners Ride
Letting Winners Ride is a strategy that minimizes the risk of a trader by cashing out 50% of the value of a trade after the initial price target has been met. Traders then move up their stop before letting the second half of the trade meet the secondary price target. Technical traders employ this strategy to profit from the small percentage of trades that continue to rise. In this way, they avoid falling prey to the house money effect.
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