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The Windfall Bias


The Windfall Bias


Ever find $50 in your coat pocket or receive an unexpected gift from a relative? Perhaps you inadvertently overpaid your credit card, and now have an extra $100 that you didn't think you had? When most people receive a windfall, they feel they can spend it freely, as if it isn't "real" money. The same thing happens when recreational gamblers unexpectedly win a jackpot. They didn't expect to win, so they decide that they might as well cavalierly spend it. They might make a few risky bets. After all, it's not their money; it belongs to the "house." Behavioral economists have shown that the same phenomenon occurs when traders and investors unexpectedly receive a windfall. They are willing to take unnecessary risks with it because "it's just the house's money." But if you want to trade like a professional, it's vital that you treat all money, windfall or not, equally. Money is money, and to trade profitably, it is vital to control risk at all times.

Why are we willing to take risks with a windfall? It's an example of what behavioral economists call "mental accounting." People informally put money into specific mental categories. Some mental categories are treated like long-term investments, while other mental categories are treated like disposable income. Windfalls are usually put into the disposable income category and treated like "mad money," which can be spent freely and carelessly. When you receive a windfall while trading, it's natural to put the unexpected profit in the "disposable income" category. But if you want to maximize your profits, it is essential that you view the money the same way as you would any other profit. Profits are hard to come by. It doesn't matter if it is unexpected. It is a profit that you should do everything you can to protect. You shouldn't take unnecessary risks with it.

Consider an example of how novice traders "play with the house's money" in order to build risk tolerance. It's difficult to take risks, and many novice traders find it anxiety provoking. One way to reduce some of the fear in the midst of a trade is to scale out of a position when it moves favorably into a predetermined target price. For example, if the market has moved favorably to a point that is midway between your entry price and price objective, you can liquidate half of your position and feel emotionally detached. You can hold the rest of the position and feel less fear because you've made enough of a profit on the trade. It's a great strategy for taking some of the pressure off, but there are two problems with this approach. First, you may have the tendency to feel that you can treat the remainder of the position as if you're playing with the house's money. You might erroneously think, "I've made enough profit, who cares what happens next?" But you still have money on the line, and it is essential that you trade according to your trading plan, rather than nonchalantly think that you have little to lose. Second, if you are a professional trader, when you hit upon a winning trade, you have to see if through. You don't have the luxury of closing out part of the position to make yourself feel better. If you continue to take the psychologically easy route halfway through the trade, and do that over and over, you won't meet your overall profit objectives. What may be a good idea for a novice or part-time trader may not be a good idea for a full-time professional trader. As a professional, you don't want to put part of your profits in a different mental account than the rest of your profits. It's all profit, no matter how you made it.

Don't fall for the windfall bias. Profit is profit. Money is money. Just because a profit was unexpected or easier than usual to make doesn't mean that it is money that you can risk indiscriminately. You're never "playing with the house's money." No matter how the money gets there, once it is in your account, it is trading capital that you must trade wisely in order to stay profitable in the long run.