I’m sat in a pub with a friend and I can’t believe my ears. He’s come into some money – £25,000 of it, to be precise. A nice lump of inheritance to put towards a property, I suggest. But he’s got other plans.
He’s got his eye on a new car. It’s faster apparently, and he tells me he’s in need of an upgrade. This one, unlike his perfectly functional current vehicle, has all the mod cons: alloy wheels, cameras, navigation, even an array of on-board entertainment.
Has he gone completely mad? He’s been saving diligently for a property deposit for 4 years. 4 years! Is he really suggesting that having received a helpful nudge into the required financial territory, he now wants to waste his money on a car he doesn’t even need? He can’t be serious.
But he’s serious alright. As I begin to politely explore this madness, I realise it has a whole corpus of irrational thinking behind it. Worse still, I realise I’ve seen this type of thinking before. I’ve seen it, I’m ashamed to say, in my own life.
Money is money
The role of money in our childhoods unquestionably bears some influence in our adulthood. Since I was knee-high, I’ve loved the thrill of growing my wealth – and evidently that’s found its way through to adulthood. But this hasn’t been a straight line. There have been blips.
The most profound of these blips happened during my three-year period at university. Not because partying is expensive, but because my attitude to money had changed in some other way. I was so focused on my degree at the time that I hardly noticed this change at all.
I had started spending my money like it wasn’t mine. It didn’t feel irresponsible because it never felt like I’d earned it.
It’s worth contextualising this a little. I was receiving a grant while I studied. This was effectively free money on top of the regular student loan that all students face, granted because my parents earned a bit less than average at the time. This became my slush fund: money I could burn on eating out much more than necessary, or on buying rounds of drinks. In short, it was money I could treat as I would never treat my own.
But here, of course, was the thinking flaw. The money was my own. It was still sitting in my bank account. It could still be used in the same way as if I’d earned it. Yet because I hadn’t put in the hard work, it took on some different meaning – and that meaning translated into behavioural change.
Money is money. We needn’t distinguish whether it was earned, won or inherited. It will serve the same purpose if we let it. Yet so often we don’t.
The house money effect
What my friend and I had in common was a psychological bias that Richard Thaler coined the house money effect. Put simply, this is the observation that we are more willing to spend and take risks with money we’ve obtained easily or unexpectedly.
Back in 1990, Richard Thaler and Eric Johnson divided a large undergraduate class into two groups. One group was told they’d won $30 and could then choose to take part in a coin toss to gamble part of their winnings. Heads would reduce their winnings to $21 and tails would increase their winnings to $39. The second group was told that they could choose between receiving the $30 or taking the coin toss.
The expected value for both decisions is the same, but the characteristics of the choices meant the students approached them very differently. The majority of the first group chose to gamble, while the second group was much more conservative, with the majority choosing to cash out on their $30.
Why? Because the house money effect is at play. Students who felt they’d won something for nothing were more willing to take a punt on increasing their winnings. After all, they’d still be up.
We shape frivolous financial decisions in the context of positive prior outcomes. We see this all too often in lottery winners, heirs and gamblers. Because the gambler won £100 on an earlier bet, he’s more comfortable losing it all on red on the roulette table later. Yet it’s still £100.
Investing and the house money effect
The house money effect isn’t limited to lottery winners, heirs and gamblers either. It can have a serious impact on investing decisions on financial markets.
We know already that past decisions play a big part in cognitive biases in investing, but the house money effect can be particularly dangerous. When we’re in profitable territory, it can encourage excessive risk taking on subsequent investments.
Such behaviour in investors is characterised by the same form of mental accounting we see in gamblers. When an investor is reinvesting profits earned via stocks, they are more willing to elevate their risk than they would be if they were investing a portion of their core wages. The reinforcing narrative of mental accounting goes something like this: “I didn’t have the money previously, so I’ve got less to lose.”
Of course, this is completely irrational. But you can see how mental accounting like this fosters the house money effect. More importantly, you can see just how damaging it can be for those of us keen to grow our wealth quickly. On the journey to financial independence, we cannot afford to frame riskier present decisions in the context of our past successes.
How to control the house money effect
If we want to beat the house money effect, we must consistently treat our investment gains as we would our earnings. The caveat here is we must do so in a way that maintains a rationally thought-out investment strategy.
The opposite effect is possible if we take this too far. We may begin to cash out on stocks because we’re treating our gains more conservatively than our normal risk profile. So we need to find the balance between treating our profits with level-headed respect and overdoing it at the expense of future gains.
When it comes to won or found money, the principles are simpler. I’m not suggesting for a moment that having won the Powerball jackpot, you should spend money in exactly the same way. Context is everything. If you’ve won a modest amount and you have ambitions to buy a house, achieve financial independence, or whatever else you may already be pursuing, the money you’ve won should go towards that goal. Treat it like money you’ve earned. That may feel a bitter pill in the short run, but you’ll be thankful for it in the long run.
On the question of inheritance, there’s more a distinct intersection between psychology and morality. We remain predisposed to the house money effect, but it’s my view that our decisions should be better guided by our morals. It’s not our hard-earned money, so we treat it differently. But it’s usually someone else’s hard-earned money. If you know what a day’s work feels like, it should be easier to treat that money with the appropriate respect.
It might not come as a surprise that my friend’s words were unrestrained financial blasphemy to my ears. I didn’t tell him as much, but I did make the case for a smarter use of the money. Having fallen into the traps of the house money effect myself, I had a solid example from which I could explain the error in his logic.
Like my friend, we’re all victims of this cognitive bias from time to time. When we find, win and even inherit money, we have a remarkable tendency to treat it differently to money we’ve earned ourselves. This is financially illogical, but natural.
The good news is that we can defend ourselves against it. When we know about the house money effect, we can better self-regulate. We can take smarter, rational choices, regulated by our own knowledge of our decision quirks.
My friend didn’t buy the car. Last week he moved into his first house with his partner. He avoided the house money effect, and now he’s thankful for it.