A sunk cost is money that was previously spent and cannot be recovered. It is proper practice to exclude all sunk costs from future calculations and decisions as the cost is unchanged by the final decision. This might sound like an incredibly simple concept, but even veteran investors and managers can fall victim to the sunk cost fallacy.
Sunk Cost Fallacy
An individual suffers from the sunk cost fallacy when they continue a behaviour based on previously invested resources. To put it simply, you are falling victim to the sunk cost fallacy when you make a decision that considers the money that has already been spent. A basic example of this would be a trip to a nice restaurant. You spy crab on the menu, and you love crab, but it’s $40. You order the crab anyway, and it’s incredible. Halfway through the meal, you start feeling full. At this point, you are no longer enjoying the food, but you continue to push through it to not waste the $40. Congratulations, you have just fallen prey to the sunk cost fallacy. That $40 was spent when you placed the order if you are no longer gaining value from each bite it makes absolutely no sense to continue eating the crab, but you will, we all have.
If you’re not entirely comfortable with the idea of sunk costs that’s okay, consider the following. You go out for a night on the town, you buy a movie ticket. 30min into the movie you hate it, it’s the worst film that you have ever seen, and you hate yourself for still being there, but you stay the full 2 hours to not waste the money. This is flawed logic; the cost of the money does not change whether you leave 30min in or stay until the end. If you hate the movie that much, you’re not wasting the money by going because the money was paid 30min ago, it is a sunk cost.
Sunk Costs in investing
So, you understand how sunk costs work, but how do they affect investing? Many ways to be truthful but one of the most common is somebody refusing to sell at a loss. It’s a well-known fact that investors tend to sell winning stocks too quickly and hold losing stocks too long. A large part of the reason behind this is that people don’t see losing stocks as a loss until they sell. This causes problems on multiple fronts as it can mean you miss out of tax-loss harvesting opportunities and momentum trends suggest that stocks that go down usually continue to fall in the short-term. This means holding your losers too long is far worse than having a loser in the first place.
How to Avoid Suffering from the Sunk Cost Fallacy
Knowing the sunk cost fallacy exists is a great start, there are many behavioural traps an investor can fall into. These traps will differ in their complexity and being aware of them won’t help you avoid them all. If you find yourself falling victim to the sunk cost fallacy, don’t panic. Even the most seasoned investor will suffer at its hands at some point. The most important thing is identifying that it happened so you can improve your decision-making next time around.