What is Sunk Cost Fallacy? How it Affects Investing Decisions?
By: Flabia Maharjan
Sunk Costs
Sunk Costs are the outlays of time and money we have already made. As a result, we cannot get them back. These costs are called irrelevant costs since these costs have already been incurred and thus, are irrelevant in decision making.
For instance, we purchased movie tickets for today. No matter if we complete the whole movie or not, the money has been spent, and there is no way one would get a refund even if the movie is terrible. Here, the money we spent purchasing the tickets are sunk costs, and while deciding whether to stay for the entire movie or not, this cost is simply irrelevant.
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Sunk Cost Fallacy
Sunk Cost Fallacy revolves around giving expenses made in the past great emphasis. So, decisions are generally based on sunk costs, leading an individual towards irrationality. What people usually feel is that they’ve invested too much to quit. The fear of acknowledging loss makes people look back at events they have no control over when their actual interest is knowing what comes next or what the future holds.
Let us understand sunk cost fallacy with an everyday example and then move on with how it affects investment decisions.
Let’s imagine a multinational company employs Jerry and Tom, one of whom will soon be transferred to a branch overseas to handle work in the respective branch. Jerry is a candidate with utmost passion and determination, while Tom is someone who has more skills and experience. The decision taken by the management is to send Jerry overseas after continuous meetings and discussions. Paperwork and contracts are signed, Visa processing is successful and Jerry begins work overseas. However, the clients are dissatisfied as his determination is not reflected in his work, which could cost the company a huge ransom.
There are two scenarios determined by what the company decides to do.
Scenario 1: The company may think that they’ve spent a lot of time, money, and effort to send Jerry overseas, from attending numerous meetings to getting the required documents ready. They feel like bringing him back is a waste of their time and money. Hence, they decide to spend more money for Jerry’s training thus, falling into the sunk cost trap.
In scenario 1, we see how the management is afraid that the hard work they’ve put in will go to waste. Hence, to save their efforts and money, they decide to invest more money to rectify the wrong that happened in the first place. Instead of being farsighted and looking for a better course of action, they stick to the past. It leads to a loss of initial as well as an additional investment. Sunk cost fallacy is believing that these past costs that have already been incurred are important and thus, play a crucial role in making rational decisions in the present.
Scenario 2: The management brings back Jerry and sends Tom as his replacement. Tom has the skills and experience to satisfy the clients overseas and generates better returns for the company with excellent performance. Here, the company ignores the initial loss to the company by looking at a bigger picture of being able to generate greater revenue in the long run.
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How Sunk Costs Affect Investment Decisions?
Now we’ll use this example as a reference to comprehend how sunk costs affect decision-making in the stock market. Let us suppose we purchased stocks of ABC Company worth Rs 300,000, which has devalued to Rs 100,000 in the present. As investors, we neither want to incur losses in our investment nor do we want the investments we made in the past to go to waste. As a result, we may purchase additional shares of the same company in larger quantities to bring down the average price. But this way, we are acting irrationally. By making this purchase, we are acting as the management in scenario 1. In order to prevent our past efforts and money from going to waste, we make additional expenses that wouldn’t yield us benefits in the future. If we continue spending more and more money, we’d be incurring greater losses than what we would have initially by selling a losing investment.
Given that we knew ABC company is performing poorly and portrays weak fundamentals, we would never invest in it in the present. We have a choice to sell our position and invest Rs 100,000 in a different stock that is likely to rise in value. Instead, we hold the position that will become worthless in the days to come. Hence, it is wise not to get attached to our investments. One ought to think rationally and logically, like in scenario 2. One must not be afraid to exit from an investment although one might have to bear initial losses. It is important to remember that every new unit of investment we put in the stock market is independent of each other.
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Why do We Fall into the Sunk Cost Trap?
The reasons we commit to sunk cost fallacy revolve mainly around emotional aspects such as fear and failure.
1. Fear of past investments becoming a waste: We feel the investment (time, effort, and money) we’ve made up until now will go to waste if we do not keep investing in a particular stock, although the stock is no longer worth investing in because the returns are questionable.
2. Fear of loss: We do not like losses. If we have paid money for something, we feel we have to do it even though we find newer and better opportunities. For instance, you’ve paid Rs 2000 for a course. The same course is being provided by another institution free of cost by an individual you admire. However, since you’ve made a payment previously, you’d feel the initial course to be more valuable than the other one. We feel a sense of loss if we do not stick to the investment we’ve made and choose a different course of action.
3. Fear of failure: We do not like to admit failures. Changing strategies is often viewed as admitting we have made a bad investment. Hence, we are more likely to commit or invest more capital to make our past investments seem valuable.
Avoiding Sunk Cost Trap
1. Investor: An investor can avoid sunk cost traps by setting investment goals. For this, investors can set performance targets on their portfolios. For instance, 15% return from portfolio within the next two years. If the goals set are not met within the stipulated time frame, it is time to re-evaluate them to see where improvements can be made to generate better returns.
2. Traders: A trader should set an exit point before entering a trade. Exit point refers to the price level at which the trader should close out an existing position. This way he/she will be able to cut off losing positions and refrain from investing more capital on losing stocks.
In conclusion, one should always ignore sunk costs. In the world of investing, we might often find ourselves attached to sunk costs. This leads us to make our investments decisions based on them. Instead of looking for a better course of action ahead of us, we make decisions based on the desire to prevent our past investments from becoming waste. We ought to look forward by acknowledging our failures and losses. The course of action that will make us the most money from now on should be executed for maximum returns.
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