If you’ve ever been to the casino and gambled, you’re probably already aware of the “House Money” effect without realizing it.
The “House Money” effect is a psychological trick by which we devalue the returns on an investment vs capital we have invested.
For example, imagine you take $500 into the casino and play roulette for an hour.
Lady luck shines upon you and you find yourself with $1,000 in chips.
You play for another hour and it doesn’t bode quite as well this time.
You end the second hour with $800.
Finally, you decide to throw down $250 on a single spin happy in the knowledge that even if it doesn’t work out you “still made $50” ($800-$250 = $550, $50 more than you came in with).
When you first came in with $500, the idea of throwing $250 on a single spin was madness, but now it seems almost a no-brainer as the downside is limited and the upside much greater.
You either leave with $50 profit or leave with $550 profit, both decidedly rosy outcomes.
However, what this false dichotomy neglects is the the third option on the table.
Namely to leave now with $300 in profit.
The key point here is that each event is unrelated to the previous events and the provenance of money has no impact on it’s value.
The $250 of ‘profit’ you put down for the final spin of the wheel has the exact same utility as the $500 you came in with, and the fact that it was given to you by the casino for your good luck is of no relevance to the current situation.
Again, the provenance of money has no impact upon it’s utility.
Anchoring Investment Costs
The parallel in investments would be a situation in which a particular investment that has had a stellar run and produced substantial gains, which you then take and put into a risky investment you otherwise would not make with your own money, or cash out and spend on something you otherwise would not buy with your own money.
The most common examples of this in today’s world can be seen in the crypto currency space in which some people have made substantial gains from relatively small investments.
A $1,000 investment in Bitcoin 5 years ago today would have purchased 92.08 Bitcoins, at a price of $10.86 each.
Today, 5 years later, those Bitcoins are worth $758,370.88, at a price of $8,236 each.
Whilst many continue to hold onto their Bitcoins, there are also many that have diversified this new found wealth into the plethora of “alt coins” – other crypto currencies such as Ethereum, Neo, etc.
Others have gone further still and used their Bitcoins to buy fancy cars, which the click-bait media often spins as such:
Whilst it makes a pretty click-bait headline, the idea that someone was able to purchase a new Lamborghini for $115 is obviously not true.
The asking price for a Lamborghini Huracan is currently around $200,000. A far cry from $115.
At the time of purchase, our guy here transferred ~$200,000 worth of bitcoins from his wallet to the dealership (either directly or via a middleman).
The fact that those same bitcoins cost $115 in 2011 is irrelevant at this point.
Instead of a Lamborghini, he could have sold the Bitcoins for cash and banked ~$200,000 in USD.
By choosing to buy the car, over selling out for cash, the end effect is the same as buying the car for cash directly.
At the point in time, he held an asset that was worth ~$200,000 but exchanges that asset for the car rather than exchanging it for cash.
Avoiding the “House Money” effect
The only real way to prevent the “House Money” effect is to start by entirely ignoring the price at which you bought into any investment.
It’s critically important to remember that the market does not care at what price you bought in to an investment.
That number is very important, for a moment, until the next trade happens at which point the price you bought in at is entirely irrelevant.
It does not matter if you bought bitcoins at $0.01 or $10,000. The only thing that matters is their value in this moment.
The most famous example of this is possibly the first ever Bitcoin transaction; the infamous “BitCoin Pizza” when someone exchanged 10,000 Bitcoins for a pizza.
The guy that purchased the pizza mined the coins himself for $0 (excluding electricity costs).
At the time, those Bitcoins were worth around $30.
Today they are over $81 Million.
There’s even a Twitter account dedicated to tracking the value of that transaction in today’s prices.
Depending on which point in time you want to take, one could conclude that it’s either a very cheap, fairly priced, or very expensive pizza.
The point is, at the point of transaction it was evenly priced, with eh past and future price of Bitcoins not impacting the present value.
Recognizing and acknowledging the “House Money” effect will make you a more competent investor.
There is no such thing as “House Money” – it is all just your money and should be evaluated in the same way.
The past and future price of an investment has no impact on its value today.
Bitcoin Prices via: https://charts.bitcoin.com/chart/price
Lamborghini story: https://www.bitsonline.com/lamborghini-bitcoin-saddington/