CandleFocus Glossary Editor
The house money effect is a classic example of how behavioral psychology can lead investors to poor financial decisions. This effect takes place when a person feels that their money is “free” because it was won rather than earned through work. People in this situation tend to be more willing to take risks, believing that the “house money” will protect them if the risk backfires.
The psychological basis of the house money effect is the same phenomenon that drives gamblers to keep playing long after they’ve lost their own money. When a gambler wins, they’re not just happy with their net gain; they convince themselves that the money they won was free, or house money, and therefore taking a risk with it won’t hurt as much because it wasn’t theirs to begin with.
Unfortunately, the house money concept has a highly detrimental effect on financial decision making. People take unnecessary risks because they feel that the house money they’ve won will somehow protect them from any losses they might incur from investing that same money. This can result in risky investments that end up losing far more money than was initially risked.
Though the house money effect is most pronounced when dealing with winnings, it can be observed in other situations as well. For example, people tend to bet more money when trading stocks with the money from a bonus. They may also be more willing to borrow money at a higher interest rate if the loan is used to invest in the stock market, in the belief that the extra return will negate the higher interest costs. And investors may also be more willing to risk venture capital money that does not belong to them, as opposed to their own personal savings.
Investors need to remember that all money, whether it came from winning a game or a bonus at work, is still their own money, and should be respected as such. This means that they should weigh their risks carefully before investing and ensure they are investing within their risk tolerance. If the house money effect causes enthusiasm to take over, remember not to go overboard. Take a step back and ensure you are making sensible long-term decisions.
The psychological basis of the house money effect is the same phenomenon that drives gamblers to keep playing long after they’ve lost their own money. When a gambler wins, they’re not just happy with their net gain; they convince themselves that the money they won was free, or house money, and therefore taking a risk with it won’t hurt as much because it wasn’t theirs to begin with.
Unfortunately, the house money concept has a highly detrimental effect on financial decision making. People take unnecessary risks because they feel that the house money they’ve won will somehow protect them from any losses they might incur from investing that same money. This can result in risky investments that end up losing far more money than was initially risked.
Though the house money effect is most pronounced when dealing with winnings, it can be observed in other situations as well. For example, people tend to bet more money when trading stocks with the money from a bonus. They may also be more willing to borrow money at a higher interest rate if the loan is used to invest in the stock market, in the belief that the extra return will negate the higher interest costs. And investors may also be more willing to risk venture capital money that does not belong to them, as opposed to their own personal savings.
Investors need to remember that all money, whether it came from winning a game or a bonus at work, is still their own money, and should be respected as such. This means that they should weigh their risks carefully before investing and ensure they are investing within their risk tolerance. If the house money effect causes enthusiasm to take over, remember not to go overboard. Take a step back and ensure you are making sensible long-term decisions.