How the “Sunk Cost Fallacy” Can Compound Your Investing Losses
Don’t throw “good money” after “bad money.”
In this article, we’ll cover the sunk cost fallacy, a pervasive cognitive bias you’ll observe both in and out of investing.
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
The Sunk Cost Fallacy — What is it?
The sunk cost fallacy is when investors justify additional future investment in something because they’ve already invested a meaningful amount into it, despite evidence suggesting this decision is probably wrong.
To understand the sunk cost fallacy, let’s start with an example from outside of investing.
Imagine there’s a new release movie in theaters you want to see, so you buy yourself a $10 movie ticket. As you’re about to leave the house to go see the movie, a trusted friend happens to call and tell you he just saw the movie and it was so awful that everyone in the theater walked out.
You hang up the phone and have now lost all desire to go see the movie. But you look down at the ticket you’re holding in your hand and think to yourself:
“I don’t even want to see the movie now. But I already spent $10 on this ticket and I can’t let it go to waste, so I might as well go anyways.”
That is the sunk cost fallacy. The $10 cost of the ticket is a sunk cost. It’s gone. You can’t get it back no matter what you decide to do next.
Rather than accept that $10 loss and spend your afternoon doing something fun or productive, you don’t want to feel like that $10 was a waste so you decide to attend the movie and basically double down on your loss!
Now, instead of just losing $10, you’ve lost $10 plus an afternoon. This is an irrational decision driven by the discomfort that comes from accepting you lost $10 on the ticket.
How does it apply to investing?
When it comes to investing, the sunk cost fallacy often shows up when investors have a losing stock position.
Similar to the disposition effect, investors sometimes choose to continue to hold a position which they no longer think is a good investment simply because they don’t want to realize the loss.
Even worse, some investors will add MORE money to the losing stock they no longer believe in, justifying their action by saying they’re “lowering their cost basis” or “dollar cost averaging.”
In that case, they’re literally doubling down on a stock they no longer want to own!
Or, to use a common phrase, they’re “throwing good money after bad money.”
What should you do instead?
The most important question is whether a stock is a good investment going forward, given all the information you have available right now. The fact that you’ve already lost money on the position is irrelevant.
Your personal loss or gain has no bearing or influence on the future prospects of the company.
Ignore your return and decide if that stock is still the best place for your money.
At the heart of both the disposition effect and the sunk cost fallacy is one of the biggest cognitive biases in all of investing: loss aversion.
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.