The special risks of investing a windfall gain

Risk seeking behavior

The danger of mental accounting

Investors always need to be alert for things that make us risk seeking. Risk seeking is bad. Risk seeking is being willing to take a risk even if the chances of success are poor. Risk seeking causes investors to lose money.

A form of what Kahneman calls Mental Accounting can take place following the sale of winners. This is related to Kahneman’s notion of Keeping Score. 

A takeover bid can sometimes produce what an investor might consider a windfall gain. A rapid rise in the market or the effects of an incipient or full bubble can produce some substantial gains in individual stocks in the portfolio.

Mental Accounting can often cause an investor to think of this as found money. There is a danger that the investor uses this money in some risk seeking investment. It is essentially the same as gamblers at a casino looking at their winnings as ‘house money’. Gamblers have a propensity to take higher risks with house money than with their original stake. This is also a result of Narrow Framing.

Let us look at further example. Consider the case of an investor who inherits stocks from an aunt. There is a very human tendency to view them differently from stocks they have bought out of their hard earned savings. The stocks bought with hard earned savings go into the ‘hard earned savings’ Mental Account.  The inherited stocks are in the ‘inheritance’ Mental Account. The investor has to be on guard against a tendency to be risk seeking with the second account.

The easy money problem ties in with the role of luck in investing. A lucky windfall can make an investor risk seeking. The money goes into the lucky windfall Mental Account. An unlucky hit can make an investor risk averse. It can undermine their confidence. There is a full chapter on fascinating subject of luck in investing, Chapter 22. Luck and investing.

Our human tendency to Mental Accounting has a sister problem. It’s called Sunk Costs. We have a special mental account for money we have laid out already.

The idea of Sunk Cost Mental Accounting is explained in what Kahneman describes as an ‘ironic example that Thaler related. “Two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket; the other was on his way to purchase a ticket when he got one free from a friend. A blizzard is announced for the night of the game. Which of the two ticket holder is more likely to brave the blizzard to see the game?” (Kahneman, 2011)p.343.

Mental accounting explains why the fan who paid is more likely to brave the blizzard. Kahneman writes: “For Humans, mental accounts are a form of narrow framing; they keep things under control and manageable by a finite mind.” He adds: “An Econ would realize that the ticket has already been paid for and cannot be returned. Its cost is ‘sunk’ and the Econ would not care whether he had bought the ticket to the game of got it from a friend (if Econs have friends).” (Kahneman, 2011)p.343. Most people would be more willing to brave the blizzard when they have paid for the ticket. That is, they will be risk seeking where they have a Sunk Cost.

Want to read more about the issues raised in this post take a look at Part 2: Human Foibles and Investment Decision Making and particularly Chapter 12. Short Term Thinking and our Flower Garden and Chapter 13. Overweighting improbable outcomes

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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