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.”
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We are not purely rational decision-makers and our emotions often cause us to fall into the sunk cost fallacy. 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 results from loss aversion, status quo bias, and an ongoing commitment.
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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
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So 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.
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And I will end my blog with a famous quote by Nobel Prize winner & Father of Behavioural Finance - Daniel Kahneman.
Thanks for reading,
dr.vikas