House Money Effect

The house money effect is a behavioral finance phenomenon in which people take greater risks with profits or windfalls than they would with their original savings or wages. Because gains are mentally framed as “extra” or separate from principal, investors often treat them more freely, increasing risk tolerance and altering decision-making.

Key takeaways

• The house money effect describes greater risk-taking with prior gains versus original capital.
• It arises from mental accounting—treating profits as expendable “house money.”
• It can lead to riskier subsequent investments and poorer long-term outcomes if not managed.
• It is distinct from disciplined position-sizing strategies that mathematically increase exposure after wins.

Origin and basic mechanism

Economists Richard H. Thaler and Eric J. Johnson formalized the concept, borrowing the term from gambling: a gambler who wins may bet more of the winnings because it feels like the casino’s money, not their own. In investing, recent profits can temporarily raise an investor’s risk tolerance. For example, an investor who just profited from a moderately risky stock may next buy an even higher-beta stock, believing losses would be offset by prior gains.

The effect is driven by mental accounting—segregating funds into different mental buckets (wages, savings, gains) and treating them unequally—even though money is fungible.

Common scenarios and examples

• Short-term trading: Profits from a successful trade lead to larger, riskier bets on the next trade.
• Windfalls: Gains from a multimonth trade are reinvested into higher-risk opportunities instead of being partially locked in.
• Longer-term investing: After an unusually strong year (e.g., +30%), investors may switch from a growth fund to a much riskier strategy rather than maintaining a consistent allocation or trimming risk.
• Employee stock options: During the dot-com boom, some employees held onto rapidly appreciating options expecting more gains, and later suffered steep losses when the market reversed.

House money effect vs. letting winners ride

“Letting winners ride” can sound similar but differs in discipline and calculation. Many technical traders manage risk by:
* Cashing out a portion of a winning position after a target is met, and
* Moving up the stop-loss on the remaining position to protect gains while allowing further upside.

When done as part of a calculated position-size strategy, increasing exposure to profitable trades can compound returns without succumbing to the psychological trap of the house money effect. The key distinction is whether the decision is rule-based and risk-controlled versus emotionally driven.

Risk tolerance and volatility

Risk tolerance is an individual’s willingness to accept variability in returns. It typically varies with age, goals, and financial situation—young investors often tolerate more risk, while those near or in retirement prioritize capital preservation.

Volatility can create trading opportunities because larger price swings enable outsized gains, but it also increases the potential for amplified losses. The house money effect can cause investors to welcome volatility for the wrong reasons—because recent gains feel protective—rather than assessing the underlying risk-reward.

Tax considerations

Short-term capital gains (assets held less than one year) are taxed at ordinary income rates. Long-term capital gains (held more than one year) are taxed at preferential rates (commonly 0%, 15%, or 20% depending on income). Tax implications can affect whether it makes sense to realize gains or rotate into new positions.

Practical guidance to avoid the trap

• Define and follow a written investment plan with allocation targets and rebalancing rules.
• Consider taking partial profits after large gains to lock in returns and reduce emotional risk-taking.
• Use systematic position-sizing rather than ad-hoc increases in exposure.
• Adjust risk profile thoughtfully after windfalls—either maintain discipline or become more conservative, rather than automatically taking bigger risks.
• Review tax consequences before rotating profits into new, riskier investments.

Further reading

• Thaler, R. H., & Johnson, E. J. (1990). “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice.” Management Science.
• IRS Topic: Capital Gains and Losses.