Despite trying to understand more than 60 cognitive biases by writing about them, I just realized that I have yet to share anything about the “classic”—the Sunk Cost Fallacy.
Caution: Any resemblance to the current market is purely coincidental.
Simply put, the sunk cost fallacy is the tendency to “throw good money after bad.”
Economists would label this behavior irrational; it’s inefficient because it mis-allocates resources by depending on information that’s irrelevant to the decision being made. Still we honour already spent resources that aren’t affected by present or future decisions.
The Sunk Cost Fallacy is most dangerous when we have invested a lot of time, money, energy or love (= the resources) 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, and the urge to continue, becomes. And so, the greater the loss aversion becomes.
Investors in the stock markets fall victim to the sunk cost fallacy all the time. It happens when they double down on a plunging stock, not because they believe in its future, but because they feel the need to make back losses. Moreover, they often base their trading decisions on acquisition prices.
“I lost so much money with this stock, I can’t sell it now,” they say.
This is irrational.
The acquisition price shouldn’t play a role (Anchoring Bias!). What counts is the stock’s future performance (and the future performance of alternative investments).
Ironically, the more money a stock loses, the more investors tend to stick by it.
This volition or choice to stay the course is solely a human trait. Animals don’t care about the amount that they have invested or how much goes to waste, since they are only able to see immediate losses and gains. In fact, we behave identically when we are young (and in our toddler years), but as soon as we become adult human beings, we develop the “gift” of reflection and regret.
Rational decision-making requires us to forget about the costs incurred to date, to not reflect upon the past. Regardless of how much we have already invested, only our assessment of the future costs and benefits counts.
What can we do against this fallacy?
We should be willing to buy more of any stock that we are currently holding. Because if we are unwilling to buy more of it, why are we holding it? The sunk cost fallacy is the reason.
Buy—every quarter—additional stocks in your three worst performers. If you’re unable to bring yourself to do that, you’re suffering from the sunk cost fallacy. Better to sell them and move on.
But back to the FarmVille App: It runs solely on the effects of the sunk cost fallacy and is, therefore, an invaluable tool for understanding your weakness in the face of losses.
So, how many hours have you sunk into Farmville—or any similar online game—by subconsciously trying to avoid negative emotions? Could there be a correlation to the number of stocks you have in your portfolio with deep losses right now?
Lastly, you don’t have to confess everything in the comments section below, but you should reflect on both questions at the very least.
“Accept the fact that losses (ideally small ones) are part of the game of trading and investing. The most likely long-term winner is the person who is the best loser.” — Phantom of the Pits, trading legend
“Better a little caution than a great regret.” — George Samuel Clason (author of “The Richest Man in Babylon”)