Avoiding Sunk Cost Fallacy: Guidance for Investment Decision-Making

June 10 2024

Have you ever held on to a failing investment for way too long, hoping for it to “bounce back” to its original purchase price? Did you have a sense of attachment to your investment based on the time and money you had expended?  Don’t worry, it’s not your fault. Here is why this is a common problem with investors today.

As fiduciary investment advisors, it is our job to make decisions that serve your best interest. We see first-hand how sunk cost fallacy can prevent investors from making informed investment choices. Learn more about what the sunk cost fallacy is, how it relates to loss aversion, and how investors can avoid falling into this trap.

What is Sunk Cost Fallacy?

In the wealth management industry, the term “sunk cost fallacy” refers to people’s tendency to keep financing investments even when it’s clear the costs outweigh the potential benefit. This irrational behavior is driven by the belief that since you’ve already invested so much, you should continue investing to justify the initial investment or recover losses.

Behavioral finance and financial psychology explain why people accept the sunk cost fallacy. Of these, loss aversion is probably the most well-known and it refers to the instinct people have to avoid losing money, which is more intense than gaining the same amount of money. The psychological theory of loss aversion states that investors are willing to project their losses longer than their gains since they do not want to feel the pain of accepting a loss.

Loss aversion is related to sunk costs since managers are locked into decisions they made in the past and are unable to recover them, they feel a sense of loss which makes them continue with the decision despite it being costly.

Sunk cost and the concept of loss aversion are in fact related. Whenever investors incur a loss on their investment, the initial money spent on the venture is considered a sunk cost, which cannot be recovered. However, instead of taking the loss and investing the money in other better opportunities, they stay fixed on the investment for this reason alone. This is compounded by the fact that humans are ‘loss averse’, which means that investors will, at times, hold onto poorly-performing investments in the hope of recovering the initial capital they invested.

Let’s consider a hypothetical scenario:

Take, for instance, Mary who invested in Company XYZ stocks at $50 each, believing such a venture was lucrative. This was the position until the value of the stock reduced to $40 per share. Nevertheless, when it comes to the period of realization, due to the poor performance of the stock and its rather uncertain prospects, Mary prefers to remain patient. Why? She has put in $10,000 and cannot afford to take a hit, especially given that she must avoid realizing a loss. This decision, which stems from the sunk cost fallacy and the tenure of loss aversion deprives her of the opportunity of investing in other opportunities that could yield better returns.

Avoiding Sunk Cost Fallacy in Investment Decision-Making

Focus on Future Prospects: Instead of the concern about previous investments and attempts to achieve a corresponding income, it is necessary to assess each decision for its future yield. Because we have no control over past investment decisions, the only relevant decisions involve the future of your investment portfolio.

Set Clear Investment Criteria: Establish prior standards for disposing investments such as minimum performance levels or years in investment. Objective criteria for when to buy or sell alleviates the influence of emotional biases. Reflect upon the following question: Would the investor purchase this particular investment today? If the answer is “no”, consider selling it.

Focus on the Big Picture: It is a fundamental approach of reducing the level of risk because no investor is safe from incurring a loss with any investment. Thus, it is possible to avoid the negative consequences of sunk costs for portfolio diversification of investments by different classes, industries, and geographic locations. Just be aware that the idea here is to optimize the gain on the whole portfolio; it is not a strategy that seeks to minimize any losses on a particular stock.

Seek Objective Advice: Seek the services of a financial advisor who will be able to make fair recommendations to you and ensure that you make reasonable decisions taking into consideration objectives and constraints.

In conclusion, it is beneficial for investors to understand and avoid the issues related to the sunk cost fallacy in the actual investment process, empowering them to make the right decisions to improve their long-term welfare. Keep in mind that it is not about recovering for the previous losses; it is about leveraging future gain.