The house money effect is a theory used to explain the tendency of investors to take on greater risk when reinvesting profit earned through investing than they would when investing their savings or wages. People will often think about investment income as separate from the money they earned in other ways, which distorts their mental accounting.
Because that money is incorrectly considered somehow “extra” or “separate” from money earned in other ways, investors will invest it with a much higher risk tolerance than they would otherwise, thereby skewing their investment decisions.
The effect can be attributed to the perception that the investor has new money that wasn’t theirs.
There are many examples of this effect, but all show a common lack of rigor.
House money effect is not to be confused with a predetermined, mathematically calculated strategy of increasing position size when greater than anticipated gains occur.
Richard H. Thaler and Eric J. Johnson of the Cornell University Johnson Graduate School of Management first defined the “house money effect,” borrowing the term from casinos. The term makes reference to a gambler who takes winnings from previous bets and uses some or all of them in subsequent bets.
The house money effect suggests, for example, that individuals tend to buy higher-risk stocks or other assets after profitable trades. For example, after earning a short-term profit from a stock with a beta of 1.5, it’s not uncommon for an investor to next trade a stock with a beta of 2 or more. This is because the recent successful outcome in trading the first stock with above-average risk temporarily lowers the investor’s risk tolerance. Thus, this investor next seeks even more risk.
Windfall trades may also bring on the house money effect. Say an investor more than doubles their profit on a longer-term trade held for four months. Instead of next taking on a less-risky trade or cashing out some proceeds to preserve the profit, the house money effect suggests she may next take on another risky trade, not fearing a drawdown as long as some of the original gain is preserved.
Longer-term investors sometimes suffer a similar fate. Say an investor in a growth-oriented mutual fund earns more than 30% in a year’s time, largely driven by very strong market conditions. Keep in mind, the average stock gain tends to be roughly 6% to 8% a year. Now say this investor leaves the growth-oriented fund at year’s end to next invest in an aggressive long-short hedge fund. This may be an example of the house money effect temporarily increasing the investor’s risk tolerance.
For longer-term investors, one of two courses of action tends to be preferable to the house money effect: Either staying the course and maintaining a steady risk tolerance, or becoming slightly more conservative after big windfalls.
Of note, the house money effect also carries over to company stock options. In the dot-com boom, some employees refused to exercise their stock options over time, believing it was better to keep them and let them triple, then triple again. This strategy significantly stung workers in 2000, when some paper millionaires lost it all.
A technical analyst tends to draw a distinction between the house money effect and the concept of “letting winners ride.” On the contrary, one way technical traders manage risk is by cashing out half the value of a trade after meeting an initial price target. Then, technical traders tend to move up their stop before giving the second half of the trade a chance to meet a secondary price target.
Many technical traders utilize some version of this practice, in an effort to continue to profit from the minority of trades that continue to move up and up, which still holds to the spirit of letting winners ride while not falling victim to the house money effect. The difference between these two concepts is actually one of calculation. Letting winners ride in a mathematically calculated position-size strategy is an excellent way of compounding gains. Some traders have, in the past, documented how such strategies were instrumental in their success.