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The house money effect, proposed to describe the effect of prior outcomes on risky choice, was introduced to finance by Thaler and Johnson (1990). Agents that are subject to the house money effect are inclined to take larger risks when prior outcomes have been positive. The house money effect is an example of mental accounting, in which agents mentally keep quantities of money in artificially separate "accounts." Agents that exhibit the house money effect consider large or unexpected wealth gains to be distinct from the rest of their wealth, and are thus more willing to gamble with such gains than they ordinarily would be. Thaler and Johnson argue that the house money effect is consistent with prospect theory (Kahneman and Tversky, 1979) if agents apply "hedonic editing" to the gambles they face. [ABSTRACT FROM AUTHOR]

Loss aversion is one of several behaviorally motivated descriptions of choice under uncertainty that together constitute the Prospect Theory proposed by Kahneman and Tversky (1979). In the economic literature, loss aversion is commonly referred to as first order risk aversion. For agents that exhibit loss averse preferences, "losses loom larger than gains," implying that their utility depends both on whether they have won or lost (relative to a pre-specified benchmark) and the magnitude of the gain or loss. If π(t) is the quantity that an agent is willing to pay to avoid a gamble of magnitude ∊t, where ∊ is an actuarially fair random variable, then standard expected utility theory with conventional risk aversion implies that π′(0) = 0, or that agents are indifferent to small gambles. By contrast, loss averse preferences are characterized by or by significant aversion to small gambles (Segal and Spivak, 1990). Loss averse preferences are an example of reference-dependent utility, in which total utility does not depend on the level of wealth or consumption, but on a comparison of wealth or consumption to some time-varying benchmark level. [ABSTRACT FROM AUTHOR]