Sunk Cost Fallacy
After discussing Authority Bias, in this blog, we will discuss SUNK COST FALLACY.
As per Wikipedia, In economics and business decision-making, a SUNK COST (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered.
The SUNK COST FALLACY is a logical fallacy that entails sticking with a loss-making or failed venture because you’ve already invested a significant amount of time, money, or other resources that you can’t get back. It hinges on the idea that because you’ve already incurred costs, you need to stick with the endeavour in order to “get your money’s worth.”
The sunk cost fallacy occurs because we are not purely rational decision-makers and are often influenced by our emotions. When we have previously invested in a choice, we are likely to feel guilty or regretful if we do not follow through on that decision.
This fallacy, which is related to loss aversion and status quo bias, can also be viewed as bias resulting from an ongoing commitment.
In investing also we this fallacy many times. The bias which can lead to this fallacy is LOSS AVERSION. The pain of losing is twice that of the gains. So we keep on holding on to the losers. And if you add your Endowment bias/Confirmation Bias to this, it converts into sunk cost fallacy.
Loss Aversion + Confirmation Bias / Endowment Bias = Sunk Cost Fallacy
Loss Aversion + Status Quo Bias = Sunk Cost Fallacy
So the solution?
Since the sunk cost fallacy is thought to be caused by our desire to avoid negative emotions, we should try to take our emotions out of the equation when making a decision.
So how to take out emotions from your investing decisions?
Again it boils down to a few basic ideas
Use a checklist while buying the stocks. This will help in relying on the Numbers more than the Narrative.
Keep a strict stop-loss. Avoid averaging down especially if the business is out of your circle of competence.
As Peter Lynch says, water the flowers and remove the weeds - which means Cut your losses in loss-making stocks and put that capital in your profit-making stocks.
And I will end my blog with a famous quote by Noble Prize winner & Father of Behahoual Finance - Daniel Kahnem
Hope you liked this write-up on Sunk Cost Fallacy. In the next blog, we will discuss perhaps the most common bias - LOSS AVERSION.
Thanks for reading,
dr.vikas