Sink or Swim – How the Sunk Cost Fallacy Could Be Affecting Your Investment Decisions

Written by: Harmony Wagner, CFP®

In the age of technology, good investing principles are widely available to even the most novice investor. Anyone has access to information about how to succeed in the markets and avoid potential pitfalls, so one might expect people to behave with near perfect rationality in their investment decisions. However, investors are humans and are often affected by emotions that steer them away from rational robotic behavior.

 

The Sunk Cost Fallacy

In behavioral finance, there is a phenomenon called the Sunk Cost Fallacy. The sunk cost fallacy describes the desire to keep a particular investment based on the original costs associated with that investment, or the sunk cost. This is an irrational way to evaluate a decision because money, time, and resources that have already been sunk into a project cannot be recovered regardless of what future path is chosen. The historical costs do not have any bearing on the future performance of that investment and should be excluded from consideration when deciding whether to move forward or abandon the investment.

Let’s imagine an investor, Jack, who bought a share of ABC stock at $100 a year ago. Today, one share of ABC stock is worth $70, and at that price, Investor Jill buys a share. Both Jack and Jill own a share of stock that is currently worth $70, and since they both own the same company, the future outlook for their respective shares is identical. However, Jack may have very different emotions about selling the stock than Jill would since he paid a much higher price for that share. That’s the sunk cost fallacy in action. When shareholders become fixated on selling stock or fund at a higher price than what they paid for it, they may end up holding on to something longer than they should and losing even more money in the position long-term.

Many investors who operate under this fallacy may believe they are acting prudently by holding onto their loss position until it recovers so they can adhere to the old adage to “buy low and sell high.” It’s important to remember that while that principle is prudent general advice for the broad stock market, it doesn’t always apply to individual positions. Stock markets historically have always trended upwards in the long-term, but that trendline is not the same for individual stocks, which can experience sustained periods of poor performance, and can even become worthless. If you hold an individual stock that has lost value since you purchased it, that stock is not guaranteed to return to its original value in a reasonable timeframe, or at all. If that position does not recover or recovers very slowly, an investor is missing out on the growth that could have been achieved by investing in something else with better growth potential. From a tax perspective, there may even be a benefit to selling out of a depreciated position to realize losses that can reduce tax liability. However, the emotions of selling an underperforming stock can often cloud the financial benefits that may exist from doing so.

The sunk cost fallacy is prevalent not only in finance but also in everyday life. Have you ever started a DIY home improvement project that went south, but you were hesitant to stop because you had already put a whole weekend's worth of time into it? Have you ever known someone who stayed in a poor work environment longer than they should because they had put so much time in with that employer? Both of those examples show how this irrational line of thinking can affect other aspects of life.

To avoid repeating history’s mistakes, it’s crucial to not only identify what those mistakes were, but also to recognize the thought patterns that contributed to the irrational behavior. It’s human nature to cling to things that we have put a lot of money, time, and effort into. If investors can identify that tendency and refocus on variables that do matter, they can prevent the sunk cost fallacy from impacting portfolio returns in the future.

Working with a financial advisor can help take the emotion out of investing. Contact our office to learn more.

Bouchey Financial Group has local offices in Saratoga Springs and Historic Downtown Troy, NY.