I had gone for a music concert yesterday evening with my wife. It was a great show – but it rained quite heavily a couple of hours before the show, and there were real chances of the show getting cancelled due to it. While at my house before starting, it was natural for us to think whether the show would happen, and if we should go – specially the distance being long, and traffic chock-a-block while the drizzle had subdued a bit. But the one thing that tilted the decision in favor of going was the fact that we had paid for the tickets in full already.
So what’s the point? Well – the point is that the fact that we had paid for the tickets should not have been the deciding factor. If the rains were heavy, and we had no chances of making it – that alone should have been the criterion. Because the money was gone anyway. It was a different matter that in the end the rain stopped completely, we got there on time despite the traffic, and the show was superb, and hence the risk was worth it – but sometimes it may not work out that way. And even if it does, the reason we took the decision should have been based on whether there was any risk in going or not – rather than because we had paid for the tickets. This is a common ‘sunk cost’ fallacy that a lot of investors are victims of.
Pretty similar situations are likely to arise very often in an investing lifetime. If you are stuck in a situation where a stock you bought falls a lot, assuming you are able to handle the notional fall, your immediate urge is to ‘average the price’ and takes over your thinking. In some cases, it may be the right decision, in fact over time, it may work out and end up being a smart move. But very often, the fact that you bought the stock earlier at a higher price weighs so heavily on you, that you do not evaluate, in enough detail, whether the fundamentals of the company have deteriorated, and if there is a higher risk in buying the stock now, even at the dropped price. There may be real reasons for the fall – and hence averaging out may not be the best strategy. But the ‘sunk cost’ trap comes into play, and affects your decision-making, urging you to average out – rather than buying as a result of a more rational analysis where a purchase at a lower price is deemed to be a sound investment decision irrespective of earlier transactions.
Similarly, assume that you are faced with a situation where you bought stock A and stock B for an equal amount, and a year later, you need 20% of the money invested for some reason. Stock A has gone up 30% and Stock B has fallen 10% by that time. It is likely that you will try to meet your requirements by selling Stock A – simply because you bought it at a lower price and it is 30% up. Again – that may be the ‘sunk cost’ phenomenon at play. The ideal way would be to evaluate the stocks again and then take a call on which one to sell in what quantity. If that is not possible, perhaps selling both to raise an equal amount may be a more rational decision. But the sunk cost paid for the stock weighs so heavily on the mind of the investor that it affects his decision-making, and more likely than not, he will raise money from the stock in which he is in at least some profit.
So what’s the way out of avoiding sunk cost traps? Looking at individual investments in isolation is the problem here – looking at the portfolio as a whole will likely lead to avoiding sunk cost traps. Re-balancing the portfolio (i.e. selling part of your winners and moving them to other assets) is a great long-term strategy, but only if it is set out as a deliberate strategy, and not if it is a result of a sunk cost trap. Hence, it is best if one makes a conscious effort to recognize the sunk cost behavioural trap, and ensure that decision-making is not being affected by the same. Like so many things in investing and finance, unfortunately, there is no clear answer here – on what exactly to do – but it is left best to an investor and his situation to come to a conclusion based on a clear awareness of the possibility of getting into a sunk cost trap.