House Money Effect
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.1 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 increases 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 they may next
take on another risky trade, not fearing a drawdown as long as some of the
original gains are preserved.
Longer-Term Investors and the House Money Effect
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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.
The House Money Effect vs. Letting Winners Ride
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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, ed how such
strategies were instrumental in their success.
What Is Meant by Risk Tolerance?
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Risk tolerance refers to the amount of risk an individual is
willing to take when trading or investing. An individual with a high-risk
tolerance is comfortable taking higher risks. They will invest in assets or
strategies that come with a high risk of loss but also a higher risk of return.
Individuals with a low-risk tolerance are the opposite. They do not want to
risk losing money and, therefore, choose investments that are low-risk. In
general, younger people have a higher risk tolerance as they have their entire
life to earn money or recuperate from losses. Older individuals, such as those
in retirement, do not have a high-risk tolerance, as they are focused on
preserving their money.
Is Volatility Good for Trading?
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Yes, volatility is considered good for trading. When markets
are volatile, it means there are larger price swings, which is a good
opportunity to make profits that are above average. However, on the flip side,
increased volatility also means that the chances for losses are higher as well.
And those losses would also be amplified due to larger than normal price
movements. In essence, volatility allows for trading opportunities.
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