Home/ Opinion / It is your money, not house money

Careful academic research in behavioural finance has shown that a bull market leads to behavioural biases that are likely to afflict a significant portion of investors. One such peril is famously dubbed as the “house money" effect. The idea here is very simple: an investor’s current risk appetite depends on the gains or losses made on her previous trades. An investor who has earned sudden profits is more likely to treat her returns as a windfall and assume risks that she would shun otherwise. In gamblers’ parlance, the gains are treated as “house money", which is treated quite differently compared with the proverbial hard earned money. Thus, investors are ever willing to gamble, sometimes irrationally, when they are sitting on gains.

Economists Richard H. Thaler and Eric J. Johnson study this phenomenon in their seminal paper published in the Management Science. The paper starts with a simple question about the expected behaviour of two gamblers: one who makes a series of gains and the other who had just lost money, say, due to theft, before entering Las Vegas. As the reader might have guessed, the first gambler is likely to gamble more aggressively than the second. Unfortunately, this phenomenon is not restricted to Las Vegas. Investors investing in financial markets are prone to “house money" effect and, hence, blow away their gains by taking risks that they would avoid otherwise. In some instances, even corporate managers display such a tendency while selecting investment projects.

In line with the standard practice in behavioural finance research, the authors set up a cleverly designed experiment, which clearly mimics the real life situation of a number of investors. The experiment, which involved undergraduate students, the favourite guinea pigs for behavioural scientists, was designed in such a manner that a portion of the participants started out with prior gains. They ensured this by handing over dollar bills to some participants. The experiment involved a number of gambles with varied proportions of risk and return. The researchers were interested in comparing and contrasting the gambling behaviour of participants who started out with gains with those who did not. The experiments were repeated several times.

Researchers found that prior gains increased risk seeking by about 40%. Many participants were comfortable taking risks as money involved came from a windfall. Those who did not have such a windfall were cautious as their own money was at risk.

The phenomenon manifests due to existence of what is known as mental accounting, which deviates substantially from rational accounting. An investor who loses money after winning treats the losses as reduction in gains rather than losses. Thus, the disutility from the loss is reduced substantially. In contrast, an investor who loses without experiencing prior gains tends to treat the losses as loss of capital and, hence, derives large disutility from it.

The paper also shows that the propensity to assume risks reduces when the potential loss at stake reaches the sum of all prior gains. So, the risk seeking, in most cases, is driven only by prior gains. Several other independent studies have confirmed the above findings. Raymond C. Battalio, John H. Kagel and Komain Jiranyakul investigate alternative models of choice under uncertainty. They document a substantial increase in willingness to gamble among participants who start with prior gains.

My colleagues at the Center For Analytical Finance have studied the behaviour of Indian investors, especially retail investors. They have shown that Indian investors are also prone to well known behavioural traps in investing. In fact, in many cases, the magnitude of the impact of biases seem to be higher in India compared with developed markets.

Self-discipline and control are the only weapons against behavioural pitfalls. First and foremost, one has to acknowledge the existence of such biases and know the circumstances under which one may fall prey to these. For example, the bias under focus in this article, the house money effect, is likely to manifest when investors make gains. A substantial number of investors are likely to be sitting on gains currently and, hence, now is the time when this virus is likely to be most active.

Investors must learn to treat even the gains from stock markets as a part of their own hard earned wealth and not as a lucky draw. The current gains in the market are a reward for waiting without gains for more than six years and bearing the risk of political uncertainty after election. This is no house money.

Before deciding on picking a stock, every investor must ask herself if the decision to invest is solely driven by the fact that she has made money on her pervious trades? If the answer is yes, then it is better to stay away from such stocks.

The purpose of this article is not to discourage investors. The idea here is to caution against recklessness. An investment decision should be, to the extent possible, independent of one’s recent experiences with investing. This way investors can avoid getting into stocks that fall 90% at the onset of any crisis. Even a decision to invest in penny stocks should be driven by proper analysis of risks and return and not by previous gains. There is, unfortunately, no substitute for discipline in investing.

Prasanna Tantri is associate director of Center For Analytical Finance, Indian School of Business.

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Updated: 02 Sep 2014, 07:02 PM IST
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