What is House-Money Effect? And why money is not naked
A windy fall day in the early 1980s. The wet leaves swirled about the sidewalk. Pushing my bike up the hill to school, I noticed a strange leaf at my feet. It was big and rust-brown, and only when I bent down did I realise it was a 500-Swiss-franc bill! That was the equivalent of about $250 back then, an absolute fortune for a high school student.
The money spent little time in my pocket: I soon bought myself to a top-of-the-range bike with disc brakes and Shimano gears, one of the best models around. The funny thing was, my old bike worked fine.
Admittedly, I wasn’t completely broke back then: I had managed to save up a few hundred francs through mowing grass in the neighbourhood.
However, it never crossed my mind to spend this hard-earned money on something so unnecessary. The most I treated myself to was a trip to the movies every now and then.
It was only upon reflection that I realised how irrational my behaviour had been. Money is money after all. But we don’t see it that way. Depending on how we get it, we treat it differently. Money is not naked; it is wrapped in an emotional shroud.
Try it yourself
Consider the following:
You’ve worked hard for a year. At the end of the twelve months, you have $20,000 more in your account than you had at the beginning.
What do you do?
A) Leave it sitting in the bank.
B) Invest it.
C) Use it to make necessary improvements, such as renovating your mouldy kitchen or replacing old tyres.
D) Treat yourself to a luxury cruise.
If you think like most people, you’ll opt for A, B or C.
You win $20,000 in the lottery.
What do you do with it? Choose from A, B, C or D above.
Most people now take C or D. And of course, by doing so they exhibit flawed thinking.
You can count it any way you like; $20,000 is still $20,000.
We witness similar delusions in casinos
A friend places $1,000 on the roulette table – and loses everything. When asked about this, he says:
‘I didn’t really gamble away $1,000. I won all that earlier.’
‘But it’s the same amount!’
‘Not for me,’ he laughs.
We treat money that we win, discover or inherit much more frivolously than hard-earned cash
The economist Richard Thaler calls this the house-money effect. It leads us to take bigger risks and, for this reason, many lottery winners end up worse off after they’ve cashed in their winnings. That old platitude – win some, lose some – is a feeble attempt to downplay real losses.
Thaler divided his students into two groups.
The first group learned they had won $30 and could choose to take part in the following coin toss: if it was tails, they would win $9. If heads, they would lose $9.
Seventy percent of students opted to risk it.
The second group learned they had won nothing, but that they could choose between receiving $30 or taking part in a coin toss in which heads won them $21 and tails secured $39.
The second group behaved more conservatively. Only 43% were prepared to gamble – even though the expected value for both options was the same: $30.
Marketing strategists recognise the usefulness of the house-money effect
Online gambling sites ‘reward’ you with $100 credit when you sign up. Credit card companies offer the same when you fill in the application form. Airlines present you with a few thousand miles when you join their frequent flyer clubs. Phone companies give you free call credit to get you accustomed to making lots of calls. A large part of the coupon craze stems from the house-money effect.
Be careful if you win money or if a business gives you something for free. Chances are you will pay it back with interest out of sheer exuberance. It’s better to tear the provocative clothes from this seemingly free money. Put it in workmen’s gear. Put it in your bank account or back into your own company.
The above article is from the book The Art of Thinking Clearly by Rolf Dobelli. The article is only for educational and informative purposes to explain and understand cognitive biases. It is a great book, definitely worth a read!