What is the effect of house money?
The effect of house money explains the tendency of investors and traders to take more risks when they reinvest the profits generated by stocks, bonds, futures or options than they would when they invest their savings or part of their salary. This effect assumes that certain investors will increase their risk in a given trade by using mental accounting when they realize that they risk money that they did not previously have, but have gained through their interaction with the market.
Key points to remember
- House Money Effect is a concept of behavioral finance that people risk more when they earn.
- The effect can be attributed to the perception that the investor has new money that was not theirs.
- There are many examples of this effect, but all show a common lack of rigor.
- The effect of house money should not be confused with a predetermined, mathematically calculated strategy to increase the size of the position when gains are expected to occur.
Understanding the effect of household money
Richard H. Thaler and Eric J. Johnson of Cornell University Johnson Graduate School of Management first defined “the effect of money from home”, borrowing the term from casinos. The term refers to a player who takes the winnings from previous bets and uses some or all of them in subsequent bets.
The effect of house money suggests, for example, that individuals tend to buy stocks, bonds, or other higher risk asset classes after profitable trades. For example, after making a short-term profit on a stock with a beta of 1.5, it is not uncommon for an investor to trade a stock with a beta of 2 or more. Indeed, the recent success of trading in the first security presenting an above-average risk temporarily reduces the risk tolerance of the investor. This investor therefore seeks even more risk.
Exceptional transactions can also have an effect on house money. Suppose an investor doubles more than his profit on a longer term transaction held for four months. Instead of then engaging in a less risky profession or cashing in income to preserve its profits, the effect of the house’s money suggests that it can then undertake another risky profession, without fear of a direct debit. that part of its original gain is preserved.
Longer-term investors sometimes suffer a similar fate. Suppose an investor in a growth-oriented mutual fund earns more than 30% in one year, mainly due to very strong market conditions. Keep in mind that the average inventory gain tends to be around 6% to 8% per year. Now assume that this investor leaves the growth fund at the end of the year to invest in an aggressive long-short hedge fund. This can be an example of the effect of money on the home which temporarily reduces the investor’s risk tolerance.
For longer-term investors, one of the two action plans tends to be preferable to the effect of house money: either stay the course and maintain a constant risk tolerance, or become slightly more conservative after great deals.
It should be noted that the effect of house money also affects the company’s stock options. In the dot-com boom, some employees refused to exercise their stock options over time, believing that it was better to keep them and let them triple, then triple again. This strategy stung workers considerably in 2000, when some paper millionaires lost everything.
The effect of house money against letting winners go up
A technical analyst tends to make a distinction between the effect of house money and the concept of “letting the winners go up.” On the contrary, one way that technical traders manage risk is to cash in half the value of a transaction after reaching an initial price target. Then, technical traders tend to go up before giving the second half of the trade a chance to reach a secondary price target.
Many technical traders use a certain version of this practice, in order to continue to benefit from the minority of trades which continue to progress, which remains true to the spirit of letting the winners go up without being victim of the effect of house money. The difference between these two concepts is actually one of calculation. Letting the winners roll in a mathematically calculated position size strategy is a great way to accumulate the winnings. Some traders have documented how these strategies have been instrumental in their success in the past.