The other day I was reading another finance blog that will remain nameless. As I am reading one of the posts the writer commented that they would not stop posting because they had invested thousands in their blog. That comment inspired this post on the Sunk Cost Fallacy.
What is Sunk Cost
Now let me clarify, I know the blogger was using hyperbola. That does not mean the correlation does not have value. So what is the Sunk Cost Fallacy you ask? Well lets start with the definition of a sunk cost. In economic terms a sunk cost is a cost you have invested into something in the past that is now gone. The money is by definition not recoverable.
An Example of a Sunk Cost
So an extreme example, imagine I bought an investment property for millions and it burned down. Add to the situation a hypothetical that I didn’t have insurance. That’s a sunk cost. There is no way I could get my money back from the hypothetical burned out property. It’s sunk and gone.
What is the Sunk Cost Fallacy?
Now a sunk cost fallacy meanwhile is where you basically keep doing something simply because you already sunk money into it. So in the bloggers case if they kept doing it simply because they spent thousands on the blog that would be giving into the sunk cost fallacy. Alternately in my hypothetical situation if I rebuilt the house simply because I’d dumped money into the house in the past, I would be giving into the sunk cost fallacy.
Investing and the Sunk Cost Fallacy
There are a lot of applications of this concept in personal finance, but the really important one involves investing. Whether it be in our hypothetical real estate example, or even in stocks. It’s very common for people to avoid selling a stock where they lost money simply because they don’t want to face up to their losses. I talked prior about how people tend to lag the market simply because of psychology. In writing that post I was primarily thinking of selling all stocks in a down market as a family friend did back in 2008. But it is just as real a phenomenon the other way.
The popular parlance in investing is the concept of catching a falling knife. You invest in a stock thinking it’s a value stock. The P/E is low due to some major issues, but surely it will recover. After you invest the stock starts to fall precipitously and the situation gets worse. Instead of selling for a small loss you hold on because you do not want to lose any more. Nevermind that the money is already lost. You view it as a duty to hold on as the stock falls because you invested so much already. Of course this has no influence on whether it continues to fall or recovers. The decision to sell should instead always be based on whether you would invest in the stock with new money? If no you should sell that day. But psychologically there is a tendency to want to hold on rather than lose the money you’ve already invested. That is a bad move of course, but we’re humans.
So whats the solution?
There are actually a few options:
- The easiest course of action is to invest in index funds for the long run. Buy them and hold them. If you are pre-dispositioned to do something when the market moves, then do not even look at your holdings. That being said I realize not everyone will or can listen to this.
- If you can’t stick to the index fund plan over the long run, then the secondary option is to clearly define an exit strategy for your stock investments. Set it up before you invest in the stock. Decide if the stocks go down 5% you will sell. Or if the stock goes up 20% you will sell. Set whatever limit makes the most sense to you, but do it long before you are faced with the decision to sell. Separate the emotions of selling from the decision to sell. That way when the knife falls you get out. If the stock goes up like a rocket you also sell before it enters bubble territory.
The Play Money Portfolio
I would not set these limits or really invest in individual stocks for the majority of my portfolio, because frankly market timing is a fools game. There is no way to know what the market will do next. However, I also know we are all humans. Sometimes we just can’t resist ourselves and need to invest in individual stocks. In my case I satisfy this itch by investing using “play” money. I have maybe 1% of my entire portfolio in individual stocks where I get to try my hand at being the stock market wiz. Year in and year out I fail to do as well as the market with these individual stocks. But that 1% of my funds serves the primary purpose of keeping me from playing with the rest of my portfolio. As such it is worth every dime of the lag from the market it incurs.
Setting up an Exit Strategy ahead of time
Your investments should be in line with your risk acceptance. So if you insist on buying an individual share of say a dividend stock rather than an index fund, then you should be planning to get out if, for an example, an announcement shows up that announces a potential bankruptcy. That is where setting your exit strategy up front comes into play. Once you have set that strategy you need to setup a monitoring system to know when your stock drops outside your bounds. It could be a limit order or a stop loss, thus automating staying in your bounds. It could also be monitoring for specific news triggers. Either way set those limits and stick to it. Even with my play portfolio I follow these rules.
Do you invest in individual stocks? If so how do you avoid sunk costs influencing your investment decisions?