The economics of investing with house money
Summary: When investing there are a number of behavioral finance concepts to be aware of. The house money effect is one, which focuses on the importance of considering how to enter the market with larger sums of money.
This sum can be something you have saved up for, or it can be something that you’ve received a little easier or more surprisingly. For instance, a larger bonus than expected, a homerun stock investment or the like. If your lump sum of money has come easier to you than you expected, you should be aware of the house money effect.
House moneyHouse money is a behavioral finance concept where investors risk more with money that was easily obtained. The effect can be compared to winnings from a casino. Let’s say you enter a casino with USD $500.
After an hour you are up to $1,200, meaning that your profit stands at $700. While you still want to keep the $500, as the night goes on you could end up playing a bit more loosely and risky with your profits, in order to see if you can bring home the “big win”. This behavior is similar to the house money effect, because you feel like you’ve gotten your money pretty easily so you are more willing to put it at risk.
Evening out your oddsWhen you invest your money there are ways and strategies to improve your chances of long-term success, and that could help you avoid falling into the house money trap.
Consider the Jones family. Unexpectedly, they receive an inheritance of $50,000. The Jones family's day-to-day finances are healthy. They have $60,000 in savings, the mortgage payments are ahead of schedule, and substantial savings can also be made every month. The inheritance is therefore not necessary to cover the running costs of the family. It can be seen as an unexpected, substantial financial windfall.
After a number of conversations, the Jones family decides to invest the windfall. The purpose of the investment is extra financial leeway over 20 years so they can enjoy their eventual retirement. The investment time horizon is long.
How to startMrs. Jones has been reading a lot about how to start investing. To her it is clear that she does not want a wild adventure. She understands that diversification is a good way to limit risks. She follows her broker’s advice and chooses a globally diversified portfolio. Now she knows what she wants to invest in, the next thing to figure out is exactly how much of the money she should to invest to get started.
The immediate response for many, including Mrs. Jones, would probably be to invest it all at once, as a lump sum, but that might not be the best approach in this specific situation. The reason for that is that if the Jones’ invest everything immediately, their portfolio will become very sensitive to market movements, relative to that one day when they invested.
What they could do instead is spread their investment out over e.g. 10 months and invest $5,000 per month. Doing this will make it less important to time the market, as some of it could be invested when markets are down and some when it is up, averaging out the price for the entire investment.
The take away?If you unexpectedly receive a financial windfall, don’t rush into the market. Take some time to figure out what the right approach is for you and your money. It is human nature to take more risks with unexpected money, whether you are an experienced investor or not. So remember that investing is not a “game” of all or nothing. It is wise to take enough time to build up a diversified portfolio, without trying to time the markets -- perhaps especially when starting with house money.
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