Is Sunk Cost Fallacy Making You Stupid Investor?

Most of us think that we are smart, and take logically rational decisions. But this is not true all the times. Even if we think that we are making rational decisions we occasionally fall for the sunk cost fallacy.

What is Sunk Cost Fallacy?

Sunk cost is any cost that has already been paid and cannot be recovered. It becomes a fallacy when you remains stick to it just because you have paid for it, even though sticking is going to be totally fruitless. You buy a advance movie ticket. On the movie day you catch fever. Even though you are sick, you still want to go for the movie as you have spend money on the ticket. You feel if you don’t go the money will be wasted.

People continue wasting their three hours in the theatre, when the first few minutes tells that movie is worst, not entertaining and is a waste of time. You continue till the end because you don’t want to throw away the money spend on tickets. Whether you stay or leave, the money spend on tickets is gone. We forget that we bought ticket for entertainment purpose, which the movie is not serving. We become the victim of sunk cost fallacy and stay in the theatre just to make yourself feel that you are utilizing the money you spend.

Managers continue their fruitless advertising campaign, just because they have invested some amount in the initial phase. People continue bad relationships just because they invested so much energy in the relationship, it would be wrong to end it.
“I might as well keep eating because I already bought the food.”
“I might as well keep watching this terrible movie because I’ve watched an hour of it already.”
“I might as well keep going to a bad/useless class that I paid for.”
“I might as well continue dating someone bad for me because I’ve already invested so much in them.”

Are some of the examples of sunk cost fallacy

sunk cost fallacy investing trading

Even government and organizations falls to sunk cost fallacy. Britain and France invested heavy amount in the supersonic passenger aircraft Concorde. Even though both parties, long realized that the supersonic aircraft business would never work, they continued to invest enormous amount of money in it. The project was scrapped only after it became a financial disaster. That’s why psychologist often call sunk cost fallacy Concorde effect. US government extended involvement in Vietnam War because of this. George Bush continued bombing Iraq even on knowing there are no chemicals or nuclear weapons there. Just because they had made investments in it. This extension of Vietnam and Iraq war wiped out billions of dollars for nothing.

Rolf Dobelli says in his book The Art of Thinking Clearly: Better Thinking Better Decisions

The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy or love in something. This investment becomes a reason to carry on, even if we are dealing with a lost cause. The more we invest, the greater the sunk costs are, and the greater the urge to continue becomes.

How investors fall victim to the sunk cost fallacy?

Investors or traders often anchor their trading or investing decision on the acquisition prices, the price at which they have made position in the stock. I often hear “ I lost so much money with this stock, its down too much from my price, I can’t sell it now,”

This is irrational. The price at which you bought the stock should not be the reason to continue holding. What matters is the stocks future performance. If the probability of good performance in the future is low, then you should be exiting, no matter how much amount of loss you have to bear.

People continue with the debt laded loss making company which has next to zero chances of doing well in future, just because its trading at much lower price than their entry price. They continue in the hope that someday it will recover, which they also know won’t happen.

Book the loss and investing the rest amount in something else can be more fruitful. But sunk cost fallacy prevents investors from doing this

How to overcome sunk cost fallacy?

Don’t try to continue something for wrong reasons, such as to justify non-recoverable investments. Forget about the costs, no matter how much you have already invested, only your assessment of the future costs benefits should count.

Thoughts like We’ve come this far… I have invested too much in this stock … I have waited so long in this stock , I can wait some more , Its falling from years , it won’t fall much now, I will wait for higher levels to exit etc etc are the thoughts which shows that you are becoming victim of sunk cost fallacy. When such though hits your brain, it’s time to get rational.

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