The house money effect was first described by researchers Richard Thaler and Eric Johnson in a 1990 study entitled Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice. The house money effect is a cognitive bias where investors take higher risks on reinvested capital than they would on an initial investment.
Aspect | Explanation |
---|---|
Definition of House Money Effect | The House Money Effect is a psychological phenomenon observed in decision-making and risk-taking behaviors. It refers to the tendency of individuals to take greater risks with money or assets that they perceive as “house money” or winnings from prior activities, as opposed to their own hard-earned money. The term originates from the world of gambling, where players are more likely to place riskier bets with their winnings (house money) rather than their initial stake. In broader contexts, the House Money Effect can influence financial investments, business decisions, and everyday choices. It suggests that people tend to be less risk-averse when they perceive the funds as “extra” or not part of their baseline assets. Recognizing this effect is important in understanding how individuals and organizations approach risk and financial decisions. |
Key Concepts | Several key concepts define the House Money Effect: |
– Perceived Ownership | The House Money Effect is driven by the perception of ownership over the money or assets in question. When individuals perceive the funds as “extra” or not part of their original investment, they are more willing to take risks with those funds. Perceived ownership influences risk-taking behavior. |
– Risk Tolerance | Risk tolerance refers to an individual’s willingness and comfort level with taking risks. The House Money Effect can lead to an increased risk tolerance when dealing with perceived winnings or “house money.” People may take risks they wouldn’t with their own savings or initial capital. Risk tolerance is influenced by the House Money Effect. |
– Behavioral Economics | The House Money Effect is a concept rooted in behavioral economics, a field that studies how psychological factors and biases influence economic decisions. It illustrates how non-rational factors can impact financial choices. Behavioral economics highlights the role of psychology in economic decision-making. |
– Contextual Influence | Context plays a significant role in the House Money Effect. The decision to perceive funds as “house money” is influenced by the context in which the funds were acquired. This can include gambling winnings, investment gains, or unexpected windfalls. Contextual influence shapes the House Money Effect. |
Characteristics | The House Money Effect exhibits the following characteristics: |
– Context Dependency | The House Money Effect is context-dependent, meaning it varies based on the specific circumstances and how individuals perceive their financial situation. It is more likely to be observed when individuals view the funds as “extra” or separate from their core financial resources. Context dependency is a defining characteristic of the House Money Effect. |
– Risk Perception | The effect directly impacts risk perception. When individuals perceive funds as house money, they tend to underestimate the potential risks associated with decisions involving those funds. This can lead to riskier choices. Risk perception is influenced by the House Money Effect. |
– Impact on Decision-Making | The House Money Effect can influence various decision-making scenarios, including investments, spending, and entrepreneurial ventures. It often leads to more daring choices and a willingness to take on risks that might be avoided with personal savings or initial capital. Impact on decision-making can have financial consequences. |
– Psychological Bias | The House Money Effect is considered a psychological bias that affects how individuals assess and approach financial situations. It underscores the role of cognitive biases in financial decision-making. Psychological bias is central to the House Money Effect. |
Revenue Models | The House Money Effect itself does not generate revenue; instead, it can influence financial decisions that may impact revenue in various ways: |
– Investment Decisions | In investment scenarios, individuals who perceive gains as “house money” may be more willing to invest in riskier assets or make speculative decisions. While this can lead to potential gains, it also carries higher risks that could affect investment returns. |
– Business Ventures | Entrepreneurs or business owners may be more inclined to undertake riskier business ventures or expand their operations when they view additional funds as “house money.” This can lead to opportunities for revenue growth, but it also exposes the business to increased risks. |
– Consumer Spending | Consumers who perceive their surplus funds as “extra” may engage in higher levels of discretionary spending or luxury purchases, potentially boosting revenue for businesses catering to such spending patterns. |
– Asset Allocation | In the context of asset management, individuals managing portfolios may allocate perceived winnings or “house money” differently than their core investments. This can impact the overall performance of the portfolio and, consequently, investment returns. |
Advantages | While the House Money Effect is not inherently advantageous or disadvantageous, understanding its implications can offer several advantages: |
– Risk Awareness | Recognizing the House Money Effect increases awareness of how psychological biases can influence financial decisions. This awareness can lead to more informed and balanced risk-taking behavior. |
– Better Decision-Making | Understanding the House Money Effect allows individuals and organizations to make more deliberate and rational choices when dealing with perceived winnings or additional funds. It can lead to improved financial decision-making. |
– Mitigating Risks | Organizations and investors can take steps to mitigate the potential risks associated with the House Money Effect by incorporating risk management strategies and diversification into their decision-making processes. This can help protect against excessive risk-taking. |
– Financial Planning | Incorporating the House Money Effect into financial planning can result in more balanced and realistic financial goals and strategies. It helps individuals and organizations account for potential biases in their financial plans. |
Understanding the house money effect
In the paper, Thaler and Johnson ask the reader to consider a scenario where they were attending a convention in Las Vegas. While passing the slot machines in a casino one night, they place a quarter in one slot machine and win $100.
The pair then asks the reader to consider how their gambling behavior might be affected for the rest of the evening. In other words, would they be tempted to make a few more serious wages – even if they usually refrained from the practice? The answer, in most cases, is yes. The individual would continue to place bets in the casino with house money.
Today, the house money effect is more commonly associated with investors. The effect suggests some investors tend to enter into positions with higher risk if they have already made a profit from the initial investment. Windfall trades may also induce the house money effect. When an investor triples their money in four months, for example, they may bet it all on another risky trade instead of taking profit or investing more conservatively.
Why does the house money effect occur?
The house money effect occurs because of the distinction investors make between their own capital in the form of wages or savings and the capital gains made on an investment.
In simple terms, the house money effect describes a tendency for the investor to take on more risk with money obtained easily or unexpectedly. Capital earned through employment or other means is not invested in the same way since the capital itself is harder to “earn”.
To demonstrate the attraction of easy-won gains, Thaler and Johnson conducted a study with two groups. The first group was told they’d won $30 and could take part in a coin toss to gamble a portion of their winnings. Heads would reduce the winnings to $21 and tails would increase them to $39. The second group was given a more simple proposition: they could either accept the $30 or toss the coin under identical terms to the first group.
While the expected value for each group was the same, the members of the group who were told they’d won the money were more likely to take the coin toss and risk losing their money. The second group, whose money was not associated with gambling, was much more conservative and decided to cash out their $30.
Examples of the House Money Effect:
- Stock Market Investment: An investor, let’s call her Sarah, buys shares of a tech company and sees a significant increase in the stock price, resulting in a sizable profit. Sarah experiences the house money effect and becomes more willing to take higher risks with her profits. Instead of cashing out some of her gains or diversifying her portfolio, she decides to reinvest a large portion of her profits into riskier stocks or speculative assets.
- Cryptocurrency Trading: John invests a small amount in a cryptocurrency and sees its value skyrocket within a short period. He experiences the house money effect and becomes overconfident in his trading abilities. John decides to invest more significant amounts in other cryptocurrencies without conducting thorough research or understanding the potential risks involved. His decision is influenced by the profits he made earlier, leading to higher-risk trades.
- Real Estate Investment: Mary invests in a rental property, and over time, its value appreciates substantially. As a result of the house money effect, she decides to take out a home equity loan against the property to fund another investment. This decision exposes her to higher financial risks, as she is leveraging her property’s gains to make additional investments.
- Startup Funding: Jack is an angel investor who invested in a startup during its early stages. The startup achieves significant success and receives a large funding round from a venture capital firm. Encouraged by the success of the startup, Jack decides to invest more money in riskier early-stage startups without conducting thorough due diligence. He believes that his initial success with the first startup makes him more capable of identifying successful ventures.
- Gambling Behavior: The house money effect is well-documented in the context of gambling. For example, in a casino, a gambler wins a substantial amount of money early in the night while playing blackjack. Experiencing the house money effect, the gambler becomes more willing to place larger bets on riskier games or bets, believing that they are playing with “house money” and can afford to take bigger risks.
- Business Expansion: A successful small business owner decides to expand their operations after a particularly profitable quarter. They open multiple new locations without conducting thorough market research or financial analysis. The business owner is influenced by the house money effect, believing that their past success guarantees future success in the expansion.
Key takeaways:
- The house money effect is a cognitive bias where investors take higher risks on reinvested capital than they would on an initial investment.
- The house money effect was first described by researchers Richard Thaler and Eric Johnson in 1990. They described the effect in the context of a gambler in Las Vegas, who becomes more inclined to bet with house money after winning $100 on a slot machine.
- The house money effect occurs because of the distinction investors make between their own capital in the form of wages or savings and the capital gains made on an investment. Capital gains are considered more easily attained, so the investor is comfortable taking on more risk when investing them.
Key Highlights
- Definition of the House Money Effect: The house money effect is a cognitive bias in which investors are more likely to take higher risks with profits or gains from previous investments (reinvested capital) than they would with their initial investment. This effect is named after the idea that individuals may treat gains as if they were “house money” in a casino.
- Origin of the Term: The house money effect was first described in a 1990 study by Richard Thaler and Eric Johnson titled “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice.” The study used the context of gambling to illustrate the phenomenon.
- Behavioral Explanation: The house money effect suggests that individuals are more willing to take risks with gains that were obtained easily or unexpectedly (such as from investments) compared to money that they had to work harder to earn. The perceived separation between the initial investment and the subsequent gains influences their risk-taking behavior.
- Investment Behavior and Windfall Trades: The house money effect is often observed among investors. It leads to scenarios where investors take on higher risks with their profits or windfall gains instead of cashing out or diversifying their investments. This behavior may lead to risky decisions and overconfidence.
- Demonstrating the Effect: Thaler and Johnson conducted a study to demonstrate the house money effect. They offered participants the opportunity to gamble with money they had just won and found that participants were more likely to take risks with the “house money” than with their own earned money.
- Examples of the House Money Effect:
- Stock Market: Investors reinvest profits from successful trades into riskier assets.
- Cryptocurrency: Traders make higher-risk investments after experiencing significant gains in the market.
- Real Estate: Property owners leverage property gains for additional investments.
- Startup Funding: Early success leads to riskier investments in startups.
- Gambling: Gamblers place larger bets after early wins.
- Business Expansion: Business owners expand without thorough analysis after profitable periods.
Related Framework | Description | When to Apply |
---|---|---|
House Money Effect | The House Money Effect, a concept from behavioral economics, describes how individuals tend to take greater risks with money perceived as “house money” or winnings from prior gambling or investment activities. After experiencing gains or windfalls, individuals may view these funds as less valuable or less “real” than their original stake, leading to increased risk-taking behavior and less conservative decision-making. This effect is influenced by loss aversion and mental accounting, where individuals segregate their money into different mental accounts based on its source or intended use. Understanding the House Money Effect can inform financial decision-making, investment strategies, and risk management by recognizing the psychological biases that influence individuals’ perceptions of money and their propensity for risk-taking behavior. | When evaluating investment decisions, managing financial portfolios, or designing incentive structures, applying the House Money Effect to recognize and mitigate the influence of windfall gains on individuals’ risk-taking behavior, thus promoting rational decision-making, diversification strategies, and risk management practices to safeguard financial assets and achieve long-term financial goals. |
Endowment Effect | The Endowment Effect, a concept from behavioral economics, refers to individuals’ tendency to value objects or assets they own more highly than identical objects or assets they do not own. This bias arises from the attachment and sense of ownership individuals feel towards their possessions, leading them to overvalue these items and demand a higher price to part with them than they would be willing to pay to acquire the same items. The Endowment Effect can influence various economic transactions, such as buying, selling, trading, or negotiating, and has implications for pricing strategies, market efficiency, and consumer behavior. Recognizing the Endowment Effect can inform pricing strategies, negotiation tactics, and decision-making processes by understanding the psychological factors that affect individuals’ valuations and preferences. | When setting prices, negotiating contracts, or conducting market research, applying the Endowment Effect to anticipate and address individuals’ valuations and preferences, thus optimizing pricing strategies, negotiation outcomes, and marketing efforts by aligning product offerings, messaging, and incentives with consumers’ perceptions of value and attachment towards their possessions, enhancing customer satisfaction and maximizing economic efficiency and profitability. |
Loss Aversion | Loss Aversion, a concept from behavioral economics, refers to individuals’ tendency to prefer avoiding losses over acquiring equivalent gains. Proposed by Daniel Kahneman and Amos Tversky, loss aversion suggests that losses loom larger than gains of the same magnitude, leading individuals to make risk-averse decisions to avoid potential losses, even when the potential gains outweigh the potential losses objectively. Loss aversion influences decision-making across various domains, including financial investments, consumer choices, and organizational behavior, and has implications for risk management, decision analysis, and public policy. Understanding loss aversion can inform risk assessments, decision frameworks, and incentive structures by recognizing the asymmetrical impact of losses on individuals’ preferences and behaviors. | When designing incentives, framing messages, or evaluating risks, applying loss aversion to anticipate individuals’ risk preferences and decision biases, thus designing interventions, policies, and strategies that mitigate the impact of potential losses and leverage the motivational power of loss aversion to promote desired behaviors, enhance risk management practices, and improve decision outcomes across different contexts and stakeholders. |
Sunk Cost Fallacy | The Sunk Cost Fallacy is a cognitive bias where individuals irrationally consider unrecoverable costs (sunk costs) when making decisions, leading them to continue investing resources in a failing endeavor due to the emotional investment or perceived obligation to justify prior investments. Despite the economic principle that sunk costs should not influence future decisions, individuals often fall prey to this fallacy, escalating commitment to suboptimal courses of action. The Sunk Cost Fallacy can affect business investments, personal relationships, and organizational decision-making, hindering rational resource allocation and risk management. Recognizing the Sunk Cost Fallacy can help individuals and organizations avoid fruitless investments and make more rational decisions by focusing on future costs and benefits rather than past investments. | When evaluating investment projects, allocating resources, or making strategic decisions, applying the Sunk Cost Fallacy to recognize and mitigate the influence of past investments on decision-making, thus promoting rational resource allocation, risk management, and strategic planning by focusing on future costs and benefits, conducting objective assessments of project viability, and avoiding the escalation of commitment to failing endeavors, fostering agility, and adaptability in response to changing circumstances and information. |
Availability Heuristic | The Availability Heuristic is a mental shortcut where individuals estimate the likelihood of events based on the ease with which relevant examples come to mind. Proposed by psychologists Amos Tversky and Daniel Kahneman, the Availability Heuristic suggests that people judge events as more probable if similar events are readily available in memory or have been recently experienced, regardless of their actual frequency or statistical probability. This bias influences decision-making, risk perceptions, and judgments across various domains, such as health behaviors, financial decisions, and assessments of societal risks. Understanding the Availability Heuristic can help individuals recognize and correct biases in judgment and decision-making processes. | When assessing risks, making judgments, or communicating information, applying the Availability Heuristic to recognize and mitigate the influence of recent experiences or vivid examples on perceptions of likelihood, thus promoting more accurate risk assessments, informed decision-making, and effective communication by considering a broader range of evidence, seeking diverse perspectives, and critically evaluating information to avoid overestimating or underestimating the probability of events, leading to more reasoned and balanced judgments and decisions. |
Anchoring Bias | Anchoring Bias is a cognitive bias where individuals rely too heavily on the first piece of information encountered (the “anchor”) when making decisions. Once an anchor is set, individuals adjust their subsequent judgments or estimates around this initial reference point, even if the anchor is arbitrary or irrelevant to the decision at hand. Anchoring Bias influences negotiations, pricing decisions, and judgments of value, leading individuals to make systematic errors in judgment and estimation. Recognizing the Anchoring Bias can help individuals make more accurate judgments and decisions by questioning and adjusting initial reference points, seeking additional information, and considering alternative perspectives. | When negotiating contracts, setting prices, or making judgments, applying the Anchoring Bias to recognize and mitigate the influence of initial reference points on decision-making, thus avoiding undue influence from arbitrary anchors, considering a broader range of information and perspectives, and making more informed judgments and decisions that reflect true value and preferences, enhancing negotiation outcomes, pricing strategies, and overall decision quality across different contexts and stakeholders. |
Framing Effect | The Framing Effect is a cognitive bias where people’s decisions are influenced by the way information is presented (framed). The same information presented in different ways can lead to different judgments and choices due to the emphasis or salience of certain aspects of the information. Framing can influence risk perceptions, policy preferences, and consumer choices, highlighting the importance of how information is framed or communicated. Understanding the Framing Effect can help individuals and organizations communicate more effectively, design persuasive messages, and influence decision-making by framing information in ways that resonate with audiences’ values, goals, and preferences. | When designing messages, communicating risks, or influencing decisions, applying the Framing Effect to shape perceptions and choices by framing information in ways that highlight relevant aspects, elicit desired emotions, or appeal to underlying motivations, thus enhancing message effectiveness, influencing decision outcomes, and fostering positive attitudes and behaviors among target audiences, leveraging framing techniques to achieve communication objectives and promote informed decision-making across diverse contexts and stakeholders. |
Confirmation Bias | Confirmation Bias is a cognitive bias where individuals tend to seek, interpret, and remember information in a way that confirms their pre-existing beliefs or hypotheses, while discounting or ignoring contradictory evidence. This bias arises from the natural tendency to seek information that aligns with one’s existing beliefs or expectations, leading to selective attention, interpretation, and memory recall. Confirmation Bias influences decision-making, problem-solving, and evaluations of evidence across various domains, including science, politics, and personal relationships. Recognizing Confirmation Bias can help individuals overcome narrow-mindedness, promote critical thinking, and make more objective judgments by actively seeking diverse perspectives, challenging assumptions, and considering alternative explanations. | When conducting research, evaluating evidence, or making judgments, applying Confirmation Bias to recognize and mitigate the influence of pre-existing beliefs on information processing and decision-making, thus promoting open-mindedness, critical thinking, and evidence-based reasoning by actively seeking diverse perspectives, questioning assumptions, and considering alternative explanations, fostering more robust judgments and conclusions that reflect a more comprehensive and balanced understanding of complex issues and phenomena across different contexts and domains. |
Bandwagon Effect | The Bandwagon Effect is a cognitive bias where individuals tend to adopt beliefs or behaviors because others around them are doing the same, leading to conformity and herd behavior. This bias arises from the social desire to fit in, gain approval, or avoid social rejection, resulting in the tendency to align with prevailing opinions or trends. The Bandwagon Effect can influence consumer choices, voting behavior, and market dynamics, shaping perceptions of popularity, credibility, and social norms. Recognizing the Bandwagon Effect can help individuals make more autonomous decisions, resist social pressure, and critically evaluate information and choices based on their merits rather than mere popularity or conformity. | When making decisions, evaluating options, or assessing information, applying the Bandwagon Effect to recognize and mitigate the influence of social conformity on decision-making, thus promoting autonomy, independence, and critical thinking by evaluating choices based on their intrinsic merits, personal values, and objectives rather than external pressures or social influences, fostering individuality and diversity of perspectives in decision-making processes across diverse contexts and social environments. |
Connected Thinking Frameworks
Convergent vs. Divergent Thinking
Law of Unintended Consequences
Read Next: Biases, Bounded Rationality, Mandela Effect, Dunning-Kruger Effect, Lindy Effect, Crowding Out Effect, Bandwagon Effect.
Main Guides: