Posted in Finance, Accounting and Economics Terms, Total Reads: 898
Definition: House Money Effect
Refers to the tendency of individual investors to take on greater risks when investing with profits attained. This effect gets its name from the casino saying, ‘playing with the house's money’. This effect was first described by Richard Thaler and Eric J. Johnson of Cornell University. The house money effect describes the influence and effect of past outcomes on future risky choices. It refers to a chronic pattern wherein people intentionally take on increased risky gambles subsequent to a profitable investment experience.
An alternate definition would be house money effect being the phenomenon of people being more risk-taking with profits obtained easily/unexpectedly, i.e this forecasts that investors tend to buy risky stocks after closing out a profitable trade. In gambling, experience tells us that players are often influenced by prior outcomes. After a gambler wins money from ‘the house’, they exhibit a higher risk-seeking behaviour. This in short is the gist of the house money effect – previous gains lead to a greater risk taking in subsequent efforts. This feeling is akin to ‘playing with the house's money’ as is the case with gamblers.
Mental accounting refers to an implicit system of accounting, which causes an aberration from the expected utility theory of a rational investor. The house money effect is stated to be an example of mental accounting, where capital is separated from recent profits, leading gamblers to view those profits as more disposable. Consequently they are incentivised to take larger risks with the profits. Large or unexpected wealth gains appear to be distinct from the rest of their wealth, thus gamblers are more willing to gamble with such gains than usual. Individuals maintain mental accounts for different sources of wealth, for example, incomes, money from a windfall, etc. Consequently these mental accounts of money are treated differently and settled separately as well. For example, windfall gains, such as that from a lottery are likely to be spent differently compared to regular income. Mental accounting generally works through a non-fungibility mode.
When gains are significantly considerable, individuals tend to accept and take on greater risk. After large winnings, gamblers do not yet regard the winnings as their own, and since they do not fully integrate their winnings with their own income, they act as though they are betting on the casino’s money. This illustration of the house money effect shows that persons are more willing to take risks after a windfall, even if they are risk averse. However this effect is seen only after a gain, wherein their risk taking propensity increases. House money effect is considered consistent with prospect theory.
Impact of prior outcomes on decision making & individuals’ risk attitudes cannot be ignored. Loss aversion is the basic tenet of decision making behaviour - house money effect essentially reflects reduced loss aversion. Increased risk taking post gains is counterbalanced with reduced risk taking following losses.
Investor characteristics also have a role to money in house money effect incidences, with high wealth level investors, and diverse portfolio holders being less susceptible to behavioural biases such as the house money effect.