What is the House Money Effect?
The ‘House Money Effect’ is a behavioral finance theory that explains the tendency of investors to take on greater risks when reinvesting profit earned through investing. Unlike their savings or wages, people often perceive investment income as separate, which leads to distorted mental accounting. Consequently, this perceived ’extra’ money encourages higher risk tolerance and skews investment decisions.
Key Takeaways
- Increased Risk with Winnings: Investors tend to risk more with profits than they would otherwise.
- Perception Shift: Profits are often seen as ’new’ money that wasn’t originally theirs.
- Lack of Rigor: The effect shows a common lack of disciplined decision-making.
- Not a Strategy: This effect should not be confused with calculated strategies that involve increasing position size with gains.
Taking Calculated Risks: Insights on House Money Effect
Richard H. Thaler and Eric J. Johnson first introduced the ‘House Money Effect’, borrowing the term from casinos. Imagine a gambler reinvesting winnings into subsequent bets. Similarly, investors are likely to buy higher-risk stocks or other assets after profitable trades. For instance, after a short-term profit from a stock with a beta of 1.5, an investor might go for a riskier stock with a beta of 2 or more, driven by temporarily enhanced risk tolerance.
Understanding Long-Term Impacts of the House Money Effect
Long-term investors are not immune. For example, an individual who earns over 30% in a growth-oriented mutual fund might shift to an aggressive long-short hedge fund, illustrating enhanced risk tolerance. An alternative strategy would be to either maintain consistent risk tolerance or become slightly more conservative after significant gains.
Additionally, corporate stock options can bring about the house money effect; during the dot-com boom, employees let stock options run excessively, which backfired during market downturns.
Distinguishing between House Money Effect and Letting Winners Ride
Technical analysts distinguish the house money effect from ’letting winners ride’. While a technical trader might sell half their position upon meeting an initial price target and move up their stop to capitalize on further gains, this is a calculated risk management strategy. On the contrary, the house money effect lacks this measure of calculation and discipline.
Explaining Risk Tolerance
Risk tolerance denotes the level of risk an individual is willing to take in trading or investing. Higher risk tolerance equates to comfort with assets offering potentially higher returns and losses. Typically, younger investors often have higher risk tolerance, in contrast to older individuals focused on preserving capital.
The Role of Volatility in Trading
Volatility is crucial for trading, offering opportunities for above-average profits due to larger price swings. However, the flip side is amplified losses. Volatility presents attractive trading opportunities for those willing to navigate its risks.
Understanding Capital Gains Tax on Investment Profits
Investment held for less than a year has profits taxed at regular income tax rates, whereas investments held longer face the capital gains tax. The capital gains tax rates stand at 0%, 15%, and 20% based on brackets.
Related Terms: risk tolerance, mental accounting, capital gains tax, volatility, mutual funds, hedge funds
References
- Thaler, Richard H. and Johnson, Eric J. “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice”. Management Science, vol. 36, no. 6, June 1990, pp. 643-660. Download PDF.
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
