Sunk-cost Fallacy : Distorting your objectivity.

 The 'sunk-cost fallacy' is best summed up by the phrase "throwing good money after bad". It is one of those biases which have their root in people’s aversion to losses, and like all these distortions in thinking and judgment, exists just below the level of our consciousness, setting a ‘trading trap’ with the ability to seriously undermine one's performance.

‘Sunk-costs’ are typically unrecoverable costs: In a trading and investment sense they are only unrecoverable when a position is closed out or an investment disposed of. However, this ignores the many other aspects of trading, investment in emotional capital or a particular belief about a market, time invested, cost of running a position (funding/liquidity), and opportunity cost. However, it is often the emotional investment we have put into these which can cause us to avoid closing out/cutting a position.

From a practical perspective how does the ‘Sunk-cost fallacy’ impact traders and investors?

Assume that you own a stock in the belief that it would go significantly higher over a period of a few weeks. Unfortunately, a few weeks later the stock is slightly lower. You have done your homework, you trust your own ability, and all the news since has convinced you more than ever that this is going higher. Thus to back-up your conviction you decide to buy some more. A few more weeks pass and the price is lower again, meanwhile the rest of the market has rallied strongly. At this point on a revaluation basis you are losing money, also you have suffered an opportunity cost against other stocks, you have suffered a time-cost in running the position, and significantly an emotional cost in your ‘emotional capital’ invested in this position and your view. – To close the position now would not only crystallize a loss, but in your mind it would also feel like time, effort and energy totally wasted. – This is where the trap lies, instead of cutting-out, you decide to continue with the position in the hope it will turn around, based purely on how much time, effort and energy you have already put into this for no return or a loss. - What you did however was to base your decision on the effort and resources you have put into the trade, rather than an objective future outlook. Re-stating this another way; your future outlook for this trade is based on what your currently feel about the effort and resources you have put into the trade, and not a clearly thought out perspective of the trade and the market.

As with many behavioural biases, the ‘sunk-cost fallacy’ is really the result of combination of other biases. In all cases ‘loss aversion’ will be a factor, as will the ‘endowment effect’, other factors also affecting individuals could be over-confidence, over-optimism, and 'cognitive dissonance'.

How can one combat the ‘Sunk-cost fallacy’?



This is the tough part; the causes which lead to the beliefs and behaviours which we term behavioural biases are human traits which are part of our make-up, they have helped us thrive as a species, and in many cases helped us at times as individuals. Further to this they typically reside in the sub-conscious and thus are part of our non-conscious decision making and behaviour. Nonetheless, there will be times when they are highly detrimental to our thinking and decision making, particularly in the unnatural environment of the financial markets. Identifying and recognizing when you are succumbing to the pull of biases and irrational and self-defeating behaviours is incredibly difficult,. Traders should however try and develop their ability to be on the lookout for these biases, and an aptitude for reflection and introspection is an extremely useful tool to develop. Keeping a trading journal or diary is one step you could take to help you hone this ability. Traders should also try to question their actions thus allowing a more objective assessment. Discipline and planning are of course great allies; had the investor, in the above example, written out a plan pre-committing to a certain course of action and with various what-if scenarios, he may have had a rough blueprint to guide his actions and thinking. Finally a rule base or at minimum guidelines can keep you out of trouble, this is always a slight conundrum for traders and investors, because too much rigidity stifles creativity and intuition, however good traders develop a sense of when to act in a certain way and when to adhere to their rules/guidelines.