Insider Knowledge: Exploiting the House Money Effect

Jul 24

Introduction
In trading and investing, psychological biases significantly influence decision-making. One such bias is the "House Money Effect." Understanding this effect can help traders avoid common pitfalls and take advantage of this phenomenon.

What is the House Money Effect?
The House Money Effect is a psychological phenomenon where individuals are more likely to take risks with money they have won rather than their initial capital. In trading, this means traders become more risk-tolerant after experiencing gains, treating profits as "house money" and taking on higher risks than they would with their own capital.

Why Does It Happen?
The House Money Effect occurs due to several psychological factors:

• Mental Accounting: People tend to treat money differently based on its source. Profits are often seen as less valuable than initial capital.
  
• Overconfidence: After a winning streak, traders may become overconfident in their abilities, leading to riskier trades.
  
• Loss Aversion: Gains are perceived as a buffer, reducing the fear of losses and encouraging riskier behavior.
  

Example of the House Money Effect on Crypto
In the 2021 Crypto Bull Market, we saw Bitcoin soar to all time highs. This subsequently caused many altcoins to rally really hard resulting in some 100-500x and numerous 2-3x tokens. If you observed at what point in the timeline this happened, this happened towards the end of the bull run, when everyone already knew about crypto and everybody was seemingly getting rich by buying cryptocurrencies. This was the peak of retail activity, which includes newcomers as well as those who got rich from holding tokens earlier.


This is a perfect example of the phenomenon with several key characteristics

• Was after a period of extreme gains
  
• Was causing risk assets to outperform, suggesting a higher risk tolerance in the market
  
• Immediately after the markets tanked, clearly indicating this was a massive retail loss
  

By understanding and spotting the House Money Effect, traders can better manage their emotions and make more rational trading decisions. Recognizing this bias is the first step toward mitigating its impact and maintaining a disciplined trading strategy. We hope you enjoyed reading this idea.