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Money Nov 12, 2012

Gambler’s fallacy: The lesson I learnt last Diwali

By Vivek Kaul

Kyon daren zindagi main kya hoga, kuch na hoga to tajurba hoga' - Javed Akhtar (tajubra = experience)

Experience is a great teacher, but the trouble is it only comes with time, and by then the mistakes have already been made.

Last Diwali I played teen patti for the first time with friends and family. I started cautiously with a Rs 100 bet. But with beginners luck at work I easily won the next few rounds and half an hour later I had won Rs 5,000 and was now worth Rs 5,100 in total, which included the Rs 100 I had started with as well.

Then egged on by my sister, I bet the entire Rs 5,100 blind, on the tenth round that we were playing. And against the luck of the draw, I lost.

I turned around wanting to look at my sister, but before I could say anything i.e. call her names she said "Don't worry bhaiyya you just lost a hundred rupees."

Now did I? Was that really the case? Or was something else at work?

Following the time tested method of when in doubt then Google, I came to realise that I had just become a victim of what behavioural economists (a section of economists who link human psychology to economics) call "mental accounting".

Richard Thaler, a pioneer in the field of Behavioural Economics and who coined the term mental accounting, defines it as "the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent."

This leads to what is referred to as the gambler's fallacy, the tendency of gamblers who lose their winnings, feeling that they haven't lost anything at all. Precisely, like what my sister said.

Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble into a different pocket. Image by Rishu83/Flickr ( Creative commons)

Thaler along with Cass Sunstein explains this in his book Nudge - Improving Decisions About Health, Wealth and Happiness. "You can also see mental accounting in action at the casino. Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket," write the authors.

The gamblers call their winnings 'house money'. As the authors write "The money that has recently been won is called 'house money' because in the gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as 'gambling with the house's money'; as if it was, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing to gamble with money that they consider house money."

The house money effect is even seen at work when stock markets are on an upside. Thaler and Sunstein, give the example of the late 1990s when the world was seeing the dotcom bubble.

"Mental accounting contributed to the large increase in stock prices in the 1990s, as many people took on more and more risk with the justification that they were playing only with their gains from the last few years," they write.

It isn't only while gambling and investing in stock markets that human beings categorise money in different ways. As John Allen Paulos writes in A Mathematician Plays the Stock Market "People who lose a $100 ticket on the way to a concert, for example, are less likely to buy a new one than are people who lose $100 in cash on their way to buy the ticket. Even though amounts are the same in the two scenarios, people in the former one tend to think $200 is too large an expenditure from their entertainment account and so don't buy a new ticket, while people in the latter tend of assign $100 to their entertainment account and $100 to their "unfortunate loss" account and buy the ticket."

Or sample this situation. Let's say you are at an electronics shop looking to buy a laptop. You finally decide to buy a model which costs around Rs 36,300. Just as you are paying for it a friend calls and tells you about a better deal on a website which is offering the same model for Rs 36,000? Will you stop the purchase and go back home and order the laptop from the website? The chances are no.

But consider another situation where you are out looking to buy a DVD player. You finally zero down on a model that costs Rs 3,000. At that point of time a friend calls and tells you that the same thing is available on a website for Rs 2,700. Will you stop the purchase and go back home and order the DVD player from the website? The answer is yes.

The funny thing is that in both the cases you would have saved Rs 300. But in one case you decided to go ahead with the transaction and in another case you did not? Why does this happen? At a fundamental level the Rs 300 we save is being categorised into different mental accounts because we are thinking in terms of percentages. Rs 300 expressed as a percentage of Rs 36,300 is very small whereas Rs 300 expressed as a percentage of Rs 3,000 is significantly larger.

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by Vivek Kaul

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