Many investors have the misconception that they make rational decisions objectively. Unfortunately, most of investor’s decisions are impaired by their emotions; the more they invest in something the harder it becomes to drop it. This is why many investors ended up with unrealized large capital losses. The ability to realize and cut losses early is essential to any investor’s financial health. In this article, we will explain how the sunk cost fallacy can affect your financial portfolio.
Sunk Cost Fallacy
A sunk cost is an incurred cost that cannot be recovered. When investors continue to follow through an investment that it is not meeting their expectations because of the time and money initially spent on it, they are committing the sunk cost fallacy.
The sunk cost fallacy is one of the reasons why many investors are continuously losing money. Instead of rationally cutting losses, investors continue their investments because they do not want to waste the resources, time and money that they have already “invested”. When people fall victim to the Sunk Cost Fallacy, they are thinking of avoiding the cost of their initial investment by continuing to invest with more time and money. However, this is a very short-sighted decision and many do not realize that this will usually result in the loss of more time and money; throwing good money after bad.
“These few stocks have been bearish for 6 months! But if I close the positions now, I will lose almost 12,000 SGD and that is around 30% of my capital! I think I will exit when I recoup my losses.”
Why Are We Susceptible to The Sunk Cost Fallacy?
There are two main reasons why investors often fall victim to the sunk cost fallacy: (1) extreme optimism and (2) level of responsibility.
- Extreme Optimism
When investors are overly optimistic, they believe that they can reverse the losses incurred. They also become less risk averse; there is an assumption that it is very unlikely for them to experience a negative event. When this happens, investors will overlook the consequences of continuing an already failing investment. Optimism shifts investor’s attention to the belief that they can regain losses. Hence, they become susceptible to the sunk cost fallacy; they will not take the losses now as there is belief that the market will allow them to breakeven.
“It is extremely unlikely that a stock will continue falling! It will get better soon! When that time comes, I’ll definitely exit the market! This allows me to at least breakeven”
- Level of Responsibility
The level of responsibility carried is also another important factor. Investors who are directly responsible for the negative consequences are more likely to commit the sunk cost fallacy. This is because (1) investors do not like to admit mistakes, (2) investors want to justify the decisions previously committed, and (3) sunk cost fallacy is a chance to “rectify” the mistakes previously made.
Surprisingly, when people are put into situations where they are not directly involved (e.g. giving advice to another investor who committed the same mistake), they are less likely to behave irrationally. These people are more likely to propose others to cut their losses to avoid further disasters and consequences.
“I don’t think I should sell right no. How can a market be bearish forever? Based on my research, this company is a good buy and I don’t think I made the wrong decision. Even if I did make a mistake, all I need is to wait for the right timing to exit!”
How to Avoid the Sunk Cost Fallacy?
It is common that many investors do not even know that they are victims of the sunk cost fallacy. Hence, it is important for investors to be wary of the decisions made when they have unrealized large capital losses. When you catch yourself following through an investment because of the already incurred losses, you should re-evaluate your decision. Telling yourself to take a step back and look at your decisions from another perspective may just save you from catching the falling knife.
Another way to avoid the sunk cost fallacy is to set pre-determined stop loss order. A stop-loss order is designed to limit an investor’s loss on a position. When a stop-loss order is in play, investors will be less likely to commit the sunk cost fallacy because the limit of how much they can lose is pre-determined. It is important to take note that the stop-loss order execution is not guaranteed (e.g. Company X falls below $3.50, the stop loss order is triggered and converts into a market order to sell Company X at the next available price. If the next price is $3.45, the shares will be sold at $3.45).
All in all, it is extremely important to be aware and reflect on the investment decisions made. The more aware investors are of their emotions and behaviour, the more likely they will catch themselves committing irrational behaviours. Plan and set out investing guidelines and rules to avoid making risky irrational decisions.