Have you ever found yourself spending a lot of money on something just because you had to spend so much time searching for it? Or did you covertly think about how much you once paid at an all-you-can-eat restaurant when contemplating another round? Then, you have most likely encountered the best example of the sunk cost fallacy!
The sunk cost fallacy describes when we think about investments or expenses that are no longer relevant because of the money or time we have already spent – even when it is clear that walking away is the best decision. It shapes our decisions irrationally. It explains why we tend to commit to old decisions over the best future gains.
Unfortunately, this problem can cause havoc for your trading account: by falling for the sunk cost trap, you could lose far more than your original investment in a frantic attempt to recover the loss.
Curious how and why this occurs? Read on! We will explain why traders stick to such irrational decisions and will provide clear strategies on how they can change their thinking and make a more rational choice while trading.
What is the Sunk Cost Fallacy?
The sunk cost fallacy is a tendency to irrationally continue with an activity when it isn’t fulfilling its expectations. This is because of the money and/or time they have previously invested. The sunk costs explain why individuals cling to failed investments, finish watching movies they don’t enjoy, eat meals that taste awful, keep clothing in their wardrobe that they never wear, and continue a struggling project that demands more and more resources even though it has little chance of succeeding.
In fact, this issue is sometimes called the Concorde fallacy, named after the unsuccessful supersonic Concorde jet program that the British and French governments insisted on finishing despite the jet’s dire predictions. The money they had previously spent on the Concorde served as a rationale for them to continue investing more – an exact explanation of throwing good money after bad.
The sunk cost fallacy is one of many examples of cognitive biases that usually result in some irrational decisions. It is illustrated by sticking with expensive decisions even when doing so results in higher expenses than simply letting go of what has already been spent. These expenses can be financial, emotional, or time-based. The inability to move on from the past taints our judgment and makes it challenging to act.
For traders, this bias is exhibited as focusing on already invested costs and endeavors during current decision-making processes.
In summary, the sunk cost fallacy explains why certain traders:
- Depend on luck
- Tend to neglect recent events and information
- Have trouble accepting even minor losses.
Why do we Fall for the Sunk Cost Fallacy?
Investors fall victim to the sunk cost fallacy when they make decisions based on past events and a desire to not lose the money or time they have previously invested, rather than minimizing their losses and making a rational decision that would benefit them most in the long run.
Many investors find it difficult to accept they have made a poor investment. It is considered as admitting failure to change strategies. Therefore, many investors tend to stick with or even spend more money on a poor investment to justify their initial decision. This is called commitment bias. The sunk cost effect becomes more pronounced when it becomes a public announcement.
Sometimes investors fall for sunk costs due to loss aversion. This is when the pain we feel from the loss of money or time is greater than when we make a similar amount of money or gain. When it comes to the sunk cost fallacy, our initial investments could seem like a waste of time or money. It feels like a loss on an emotional level, even though they are no longer valuable rationally. This leads us to persist in making decisions that yield sub-optimal results.
The framing effect is another reason. We often make decisions thinking that they will be framed either negatively or positively. Walking away from a business or investment strategy that is suffering a loss is frequently seen as a sign of failure instead of an opportunity to aim higher.
Example of the Sunk Cost Fallacy
Tina invests $1,000 in Company X’s stock in February. Its price fell to $100 in December, even though the overall market conditions and comparable stocks have grown in value over the year. She remains with Company X’s stock, which in the upcoming months loses all of its value, rather than selling it and investing the $100 in a different stock that is probably going to grow in value.
Sunk Cost Fallacy in Trading
Do sunk costs affect your trading? The short answer is yes.
Once more, it indicates that traders linger on trade because they are unable to admit defeat and adjust their perspective.
Traders and investors face difficulties with sunk costs because they:
- strongly believe in avoiding losses
- commit to an open trade arrangement
- overestimate the possible gains from their open transactions
- need to demonstrate the wisdom behind their initial financial investment
- are inclined to avoid acknowledging that the trade was a time waster
- dread regret
- disregard possible chances
- have irrational hopes for profits
- believe that making a decision too quickly may damage their reputation.
How to Avoid the Sunk Cost Fallacy?
Avoiding the sunk cost fallacy is not as simple as it appears. It takes emotional control to give up something you’ve invested a lot of resources in, and it can be difficult to spot when you’re making irrational choices.
The beauty of knowing sunk costs is that once an expense is sunk, it should not influence future decisions. Let’s take a look at a few different ways to avoid the sunk cost fallacy in your investments.
Set Investment Goals
Setting investment goals is the strongest defense against the sunk cost problem. Investors could accomplish this by setting a performance goal for their portfolio. For instance, investors may want their portfolio to yield a 10% return over the following two years or to outperform the Standard and Poor’s 500 index (S&P 500) by 2%. If the portfolio doesn’t meet these goals, it might be reassessed to determine where changes should be made to increase returns.
Devise a Trading Plan
Making a strategy before you’ve invested a sizable amount of money, time, or energy is another important approach to prevent sunk costs from impeding your investment. Determine which particular factors might cause you to give up.
For instance, you could decide to sell an asset if its price falls below a particular level or terminate the business if it isn’t profitable after a definite time.
Establish a Predetermined Exit Strategy
Investors may have a pre-established exit strategy before making a trade if they are trading individual stocks. This lessens the desire to keep putting more money and time into unsuccessful investments and helps to automatically close losing positions.
Review Your Investing Strategy & Other Options
It’s crucial to occasionally assess your other choices as well. The decisions you made years ago about your time or money may have been the appropriate ones at the time, but perhaps a better opportunity has since arisen.
Make sure the investments you make are focused on the future rather than the past. If you’re unsure, consult a specialist.
Question Yourself
Biases like the sunk cost fallacy are the result of mental shortcuts in our brains. They arise when our working memory is overloaded or momentarily inaccessible. Asking yourself deliberate questions activates your system processes and makes you less vulnerable to influences from sunk costs.
Moreover, asking the correct question at the right moment is necessary for successful trade management. So, you should ask yourself:
- What would I suggest to my friend if they were trading the same?
- Am I missing out on good trading chances that I am unaware of?
- Have the trade setup’s parameters changed?
- Is there new data that reduces the appeal of the trade?
- Am I merely attempting to show that I’m correct and the market is incorrect?
It’s Acceptable to Reconsider
Making a decision and following through on it is highly valued these days. Persistence appears as a strong quality and changing minds has a negative aspect to it. This is incorrect! The finest instance of advancement is having a change of mind. Admitting you’ve been doing things incorrectly and making the decision to change is one of the best and toughest decisions you can make. It merits praise!
A useful strategy here is to assemble a support network of individuals who push you to grow and adapt and can see your decision as a part of growth.
Conclusion
The sunk cost fallacy has the power to prevent you from achieving your aims and greatness – if you allow it. It is necessary to maintain a focus on the future rather than the past to overcome this fallacy. What is spent is already spent – be it money, time, or emotional investment. Let go of that expense and focus on the benefits you will receive from pursuing your objectives without being hindered by previous decisions.
