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What Is the House Money Effect?
Let me explain the house money effect to you directly—it's a theory in behavioral finance that shows why investors like you might take bigger risks when you're reinvesting profits from your investments, compared to when you're using your regular savings or wages. You often mentally separate investment income from money earned through other means, which messes with your accounting and decision-making.
Because you see that profit as 'extra' or somehow different, you end up investing it with a higher tolerance for risk than you normally would, which can throw off your overall investment choices.
Key Takeaways
Here's what you need to grasp: the house money effect means people risk more with their winnings than they otherwise would. This happens because they perceive the money as new and not truly theirs. You'll find many examples of this, but they all point to a lack of strict discipline in investing. Remember, don't confuse this with a planned strategy where you mathematically increase your position size after unexpected gains.
Understanding the House Money Effect
Richard H. Thaler and Eric J. Johnson from Cornell first defined this term, borrowing it from casinos where gamblers use winnings from past bets for new ones. In investing, it means you might buy higher-risk stocks or assets right after a profitable trade. For instance, if you make a short-term profit on a stock with a beta of 1.5, you could then jump to one with a beta of 2 or higher because that recent success boosts your risk tolerance temporarily, pushing you to seek even more risk.
Windfall profits can trigger it too—say you double your money on a four-month trade; instead of playing it safe next or cashing out some gains, you might dive into another risky move, figuring you can afford a loss as long as you keep some of the original profit.
Longer-Term Investors and the House Money Effect
If you're a longer-term investor, you might fall into this trap as well. Imagine earning over 30% in a year from a growth mutual fund, way above the usual 6% to 8% average stock gain, thanks to a hot market. Then, at year's end, you switch to an aggressive long-short hedge fund—that could be the house money effect ramping up your risk tolerance for a bit.
For you as a long-term player, it's usually better to stick to your course with consistent risk levels or get a tad more conservative after major wins, rather than letting this effect take over. This effect even shows up with company stock options; during the dot-com boom, some employees held onto options too long, expecting them to keep multiplying, only to lose everything when the bubble burst in 2000.
The House Money Effect vs. Letting Winners Ride
You should distinguish this from 'letting winners ride,' which technical analysts use. They manage risk by selling half a position after hitting an initial target, then adjusting stops to let the rest potentially grow. Many traders do something similar to capture big moves without getting emotional, staying true to letting winners ride but avoiding the house money pitfall.
The key difference is calculation—letting winners ride in a structured position-sizing strategy compounds gains effectively, and some successful traders have shown how it worked for them.
What Is Meant by Risk Tolerance?
Risk tolerance is simply how much risk you're willing to handle in trading or investing. If you have high tolerance, you're fine with assets or strategies that could lose big but also gain big. Low tolerance means you stick to safer options to avoid losses. Generally, younger folks like you might have higher tolerance since you have time to recover, while retirees focus on preserving capital and keep it low.
Is Volatility Good for Trading?
Yes, volatility is good for trading because it creates bigger price swings, opening doors for above-average profits. But remember, it also heightens loss risks, with those losses potentially larger due to extreme movements. In short, volatility provides trading chances, for better or worse.
What Is the Capital Gains Tax on Investment Profits?
If you hold an investment under a year, profits get taxed at your regular income rate. Hold longer than a year, and it's the capital gains rate—0%, 15%, or 20%, depending on your bracket.
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