The Sunk Cost Fallacy
In the previous article, we learned about how certain psychological factors make a huge impact on our decision-making about financial investment. We studied about what loss aversion is and how it impacts the decisions that we make. There is another psychological fallacy that is responsible for a lot of losses in the stock market.
In this article, we will have a closer look at what the sunk cost fallacy is and how it impacts decision making.
What is the Sunk Cost Fallacy?
The sunk cost fallacy describes an emotional tendency to invest more and more money, time, and effort into an endeavor that we have already invested in. Often times, individuals and businesses are not focused on the benefits that will be derived in the future. Instead, the focus is on costs that have already been incurred. In common business parlance, the sunk cost fallacy has been defined as throwing good money after bad. Traditional financial theory labels sunk costs as irrelevant. This means that sunk costs are not considered in analyses such as capital budgeting and capital rationing.
The sunk cost fallacy is closely linked to loss aversion. When investors invest in a stock or a project, they become so deeply psychologically involved that they are not willing to accept failure. Hence, they tend to invest more money trying to make the investment work. This happens because, as humans, we are trained to abhor failure. We try to hide our failure and hide the facts until the facts themselves change, and we emerge successful.
An investors failure to follow through on his/her decision causes cognitive dissonance within them. This is because when they fail to follow through on their initial decision, they somehow view it as a failure. This remains the fact that even if not committing more resources was actually the wise thing to do. If we are not aware of the sunk cost fallacy, we could make a lot of suboptimal decisions that could seriously affect our net worth.
How Stock Cost Affects Investor Behaviour
As mentioned earlier, sunk costs stem from loss aversion. Hence, all the mistakes made by investors because of loss aversion also apply to sunk costs. There are some additional mistakes which the investors make in the case of sunk costs. They are mentioned below:
How to Avoid the Sunk Cost Fallacy?
One of the best ways to avoid the sunk cost fallacy is to think of losses as useful. It is not only gains that are useful to the investor. Sometimes, losses can also be put to good use. For instance, losses faced can be used to reduce the income and therefore also reduce the tax payable. Hence, there is a small portion of a loss, which works out to be useful for the investor.
Another way to avoid getting locked in the sunk cost fallacy is to only pay attention to the aggregates. Investors should look at the aggregate return that they made on their portfolio instead of fixating on the values of certain stocks. For instance, if a stock contributes only 5% of an investors portfolio, the loss is quite small even if the value has fallen down by 50%! Hence, instead of focusing on the 50% number, the investor should think of it as a 2.5% loss on the portfolio. This will help them to avoid getting carried over by emotion and hence make rational decisions.
The bottom line is that sunk costs should ideally not be considered while making decisions. However, this is not the case in real life. Cognitive biases skew the thought process of the investor, and they are more likely to invest more in a stock that they have already invested in. If investors are no aware of this tendency and do not actively seek to avoid it, they are likely to end up throwing good money after bad.
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