Risk aversion, gambling with the house's money, and playing long shots

In 1990 Richard H. Thaler and Eric J. Johnson wrote a paper entitled “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice” (available for download at the Social Science Research Network). The paper focuses on how risk-taking behavior is affected by prior gains and losses. It definitely has repercussions for the trader and investor.

There is no need to summarize the authors’ theoretical work here. But their experiments led to three important empirical results. First, how do people respond to the chance to gain back some of their money after a loss? For instance, the subject had just lost $30 and was asked to choose between (a) doing nothing and (b) a gamble with a 50% chance to win $9 and a 50% chance to lose $9. Sixty percent of the subjects opted to do nothing.

Second, if the subject is ahead by $30, how does he respond to the chance to add to his winnings with the same $9 50-50 bet? Seventy-seven percent wanted to take the bet. They were playing with the house money. “The essence of the idea is that until the winnings are completely depleted, losses are coded as reductions in a gain, as if losing some of ‘their money’ doesn’t hurt as much as losing one’s own cash.” (p. 657)

Finally, risk aversion in the face of a previous loss can be overcome if the subject is offered the opportunity to break even (about 70% were risk-seeking in this scenario), especially with a modest outlay of money. The authors point to the proclivity for losing gamblers at the race track to bet on long shots at the end of the day. Although a risk-seeking bettor who is behind by $30 “could bet $30 on an even money favorite as a method of getting even, . . . [a] $2 bet on a 15-1 long shot offers a more attractive chance at breaking even because it does not risk losing significantly more money.” (p. 658)

The implications for the trader are obvious. First, it goes against the grain to pull the trigger after a losing trade and, by extension, after a string of losing trades (even when following a well-researched system) it requires an almost superhuman effort to take that next buy or sell signal. Second, winning traders get cocky because they no longer see themselves as playing with their own money. How many times have we read “move your stop to break even, then you’re playing with the house’s money.” The third result has two incarnations: the revenge trader who throws caution to the wind in his attempt to break even and the penny-wise and pound-foolish trader who is seduced by the siren call of out-of-the money, long shot options.