House-Money Effect - Explained
What is the House-Money Effect?
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Table of ContentsWhat is the House Money Effect?How Does the House Money Effect Work?The House Money Effect vs. Letting Winners Ride
What is the House Money Effect?
The house money describes a cognitive bias in which investors take higher risks when reinvesting than they would when investing their initial capital. This bias explains the tendency of investors to take on greater risks because they already earned profits from their investments, these risks would not have been taken at the initial investment. The house money effect was developed by Richard Thaler and Eric Johnson in their paper titled "Gambling with the house money and trying to break even." The house money effect first originated from casinos or gambling in which gamblers after making significant gains continue to play with the house money.
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How Does the House Money Effect Work?
The house money effect describes the tendency of investors to enter investment positions with higher risks simply because they already made profit from the initial investment. For instance, if an investor wants to reinvest the profit on an investment on stocks, futures contracts or bonds, the investor would take greater risks on it. The psychological thinking of cognitive bias behind the house money effect is that people segregate between capital and profits and consider profits lesser than capital, hence, taking higher risks or gambling with it. When an individual considers gains as distinct from wealth and is willing to take greater risks with the gains, the house money effect has taken place. The house money effect is sometimes a psychological trick that people fall into when they make significant profit in a short period of time. They take on greater risks or gamble with an amount they otherwise would not have gambled with ordinarily, not fearing the drawdown that might occur within the period.
The House Money Effect vs. Letting Winners Ride
Letting the winners ride is another disposition towards trading, investing and betting than the house money effect. The letting winners ride technique allows a trader or investor minimize risk by cashing out 50% of the value of a trade once the target price is met. The second half of the value allows the trader moves up its position to meet a secondary target. While some technical traders use the house money effect, many use letting the winners ride strategy by cashing out half of the profit made and reinvesting the other half without falling victim of house money effect.