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:
- Aggressive Investing: It has been observed that if investors lose a certain amount of money, their risk tolerance suddenly starts going up. The same investor who was very risk-averse to begin with, starts taking undue risks such as investing in aggressive stocks. This often happens because investors are making decisions looking in the rear-view mirror instead of looking ahead. Since they have already lost some money, they feel psychological dissonance. This is the reason that they want to recover as soon as possible. Since riskier stocks provide a higher probability of recovering those costs faster, investors often choose them. On careful evaluation, we can easily see why this is a fallacy. The decision to invest in risky stocks has no connection to the losses made in the past. Linking the two is actually a mistake being made by the investors mind.
- Averaging: In the previous article, we already discussed how investors get emotionally attached to their investments, and when the price falls, they pick up an even bigger stake in order to average out the costs. Apart from being driven by loss aversion, this is also driven by the sunk costs fallacy. This is because the investor probably would not invest in the share at all had they not lost money in it. Since they lost money in the shares, they got hooked to invest more in it.
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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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Behavioral Finance - An Introduction
- Heuristics and their role in Finance
- Advantages of Behavioral Finance
- Limitations of Behavioral Finance
- FAQs About Behavioral Finance
- Prospect Theory
- How Loss Aversion Affects Investment Decisions
- The Sunk Cost Fallacy
- The Endowment Effect
- Regret Aversion Bias
- Self-Control Bias
- Anchoring Bias in Behavioural Finance
- Confirmation Bias in Behavioral Finance
- Herd Mentality Bias
- Mental Accounting
- Recency Bias
- Overconfidence Bias
- Conservatism Bias
- Framing Bias
- Behavioral Portfolios
- Hindsight Bias
- Illusion of Control Bias
- Status Quo Bias
- Sample Size Neglect
- Optimism Bias
- Cognitive Dissonance Bias
- Home Country Bias
- Availability Bias in Behavioural Investing
- The Bias Blind Spot
- The Narrative Fallacy
- The Planning Fallacy
- Base Rate Fallacy
- Contrarian Investing
- Cultural Influences on Financial Decisions
- Behavioral Life Cycle Theory
- The Barnewall Model
- Bielard, Biel and Kaiser (BBK) Model
- Three Dimensional Pscychographic Model
- Categorizing Behavioral Biases
- Lessons Learned in Behavioural Finance