Have you ever made yourself sit through a horrible movie because, having paid for the ticket, you felt you had to get your money's worth? Some people treat their investments in a similar manner.
Behavioral economists refer to this propensity of people and organizations to stick with a losing strategy purely on the basis that they have already sunk so much time and money into it already as the "sunk cost fallacy."
As an example, a couple buys a property next to a highway under the belief that planting trees and installing double-paned windows will block out the noise. The couple invests thousands of dollars into the property, yet it is still unlivable. Rather than selling the property and accepting the loss, the couple refuses to sell the property because it would be a waste of money. This is an example of a sunk cost. Despite the strong likelihood the couple will not get their money back, they are reluctant to cut their losses and sell because that would involve an admission of defeat.
Investors will often follow this same logic when making investment decisions too. Investors speculate on a particular stock they hear about on the news or internet because they are excited about the prospects for that company or industry. When those forecasts don't come to fruition, they continue to hold onto the investment even though it has declined in value and the outlook is not as bright.
It might be a pharmaceutical company awaiting FDA approval for a new drug, or an energy company that is hyped on bullish projections for a new method of delivering sustainable energy. Later, when it becomes evident the positive expectations will not be achieved, some investors will still hold on, based on the hope they can make their money back.
The motivations behind the sunk cost fallacy are understandable. We want our investments to do well and we don't want to admit our efforts have been made in vain. Listed below are six simple rules for dealing with this challenge:
1. Accept that not every investment will be a winner. Stock prices rise and fall based on new information and the markets' collective expectations of a company's earnings. There is risk around outcomes and that is why there is the potential for returns.
2. While risk and return are related, not every risk is worth taking. Making big bets, or speculating, on individual stocks or industries leaves investors open to idiosyncratic influences like technological advancements or regulatory changes that could hinder a company's ability to operate.
3. Diversification can help reduce these individual influences. Over time, we know there is a positive rate of return on funds invested in the capital markets. We also know that expected return is not divided equally among individual stocks or uniformly across time. Therefore, it is best to spread risk across investments.
4. Understand how markets work. If you heard about the prospects for a particular company or industry on a television program or in the news, chances are that news has already been reflected in the security's price accordingly.
5. Remember your investment goals and risk tolerance. There are tens of thousands of individual stocks and bonds across the globe and there are an infinite number of possibilities in structuring a portfolio. But portfolios should be structured to meet the unique needs and risk profile of each investor, not on hot tips or the views of high-profile financial personalities.
6. Don't fall in love with your investments. Investors often go wrong by sinking emotional capital into a losing investments because they just can't let go. It's easier to maintain discipline and objectivity if you maintain a healthy distance from your portfolio.
While these six rules are simple in theory, they are challenging in practice. It's extremely difficult to distinguish between an investment that has declined in value and will not recover from one that has declined in value but still has the potential for long-term gains. Even the most famous portfolio and hedge fund managers struggle with these decisions from time to time.
However, these are all practical ways of taking our subjectivity and emotions out of the investment process and avoiding the sunk cost fallacy. This approach may not be as interesting, and may not get media attention, but keeping an emotional distance between yourself and your portfolio can help avoid some unhealthy attachments.