house-money-effect

What Is The House Money Effect? The House Money Effect In A Nutshell

Business / By / December 26, 2021

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.

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.

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.

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