This story is republished with permission from Dollars & Sense.
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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. |
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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. |
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? |
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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.
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