Consider this bet on a coin toss: Heads you win $20, tails you lose $20. Would you take this gamble?
1. Yes
2. No
What if you won $100 earlier? Now would you take this gamble?
1. Yes
2. No
What about if you had lost $20 earlier, would this gamble look any different to you?
1. Yes
2. No
Many people will take the gamble in one situation but not in another. The odds of winning the $20 remains the same in each scenario. Thus, the expected value of the gamble does not change. Since neither the risk nor the reward of the gamble change between the different situations, people’s reaction to risk must change.
One important factor in evaluating a current risky decision is past experience. People are willing to take more risk after earning gains (referred to as the “house-money” effect) and less risk after losses (referred to as the “trying-to-break-even” effect or “snakebite” effect).
After winning a big sum, amateur gamblers do not fully consider the new money as their own. Because gamblers do not fully integrate their winnings with their own money, they act like they are betting with the casino’s money. Oppositely, after experiencing a financial loss, people become less willing to take risk (“snakebite” effect). After losing money, people often feel they that will continue to be unlucky; therefore, they avoid risk.
Losers don’t always avoid risk. People often jump at the chance to make up their losses. For example, after a day of betting on horses and losing money at the racetrack, gamblers are more likely to bet on the long shots. In fact, it has been found that the proportion of money bet on long shots is greater toward the end of the race day than at the beginning.
It appears that gamblers are less likely to take this risk early in the day. However, those who have won money (“house-money” effect) or lost money (“break-even” effect) during the day are more likely to take this kind of risk. Winners take the risk on a long shot bet because they feel as though they are playing with the house’s money. Losers like the opportunity to break even without risking too much more (even though the odds of winning the bet are much less). People without significant gains or losses prefer not to take the risk.
So, how does this equate to investing? You see, the “house-money” effect shows that investors are more likely to purchase risky stocks after closing out a successful position. Interestingly, this behavior exacerbates overconfident behavior, causing these investors to trade too much and buy higher-risk stocks. The “snakebite” effect can also affect investors. New or conservative investors might decide to “give the stock market a try.” If the selected stocks quickly decline in price, the first-time stock investor might feel snake bit; afraid to get back into the market.
Whether or not you have ever exhibited the behavior detailed above, when it comes to investing it is simple to see how a structured, risk-controlled system can help investors make better decisions with their money. Often, even seasoned investors let their emotions cloud their sound judgment and end up making the wrong decision; which can be very costly. The key to investing is removing emotions from the equation, and the key to growing any portfolio is simply to ride your winners and cut your losses while they are still small.
While all investing does involve some degree of risk, it is critical to be able to objectively assess the level of risk involved. GorillaTrades can help investors of all experience levels to pursue a more calculated approach to investing, with the results to back it up. GorillaTrades takes the guesswork out of investing by telling you which specific stocks have the highest potential for capital appreciation, and then clearly explains exactly when to enter into a position, and when to exit.
Investing in stocks doesn’t have to be a crap shoot; with GorillaTrades’ expert market advice, you can invest like a gorilla. Return to GorillaTrades today!