There is a misconception that people make rational decisions based on the future value of objects, investments, and experiences. But the truth is that decisions of many people are tainted by the emotional investments they accumulate and the more they invest in something the harder it becomes to abandon it.
Let us understand this with the help of an example:
Rajesh had a very hectic and long day in the office. He had some food at home but he decided to order something from outside. Since it was late in the night, he quickly ordered food before the last restaurant closes in the next 5 minutes. After 45 minutes, he received his order and just after taking the first bite, he realized that it was pathetic and unpalatable.
He knew the food that was kept at home will taste much better but still decided to eat the food that he has ordered. He thought “Have I paid money and waited for 45 minutes for nothing?”
Rajesh is suffering from a case of sunk cost fallacy. He paid for the food and waited for it should not be a factor in deciding whether he should eat it or not because in either case the cost is paid and the time is lost. However, if he had eaten the food at home, he would have had a better eating experience.
Let’s see how sunk cost fallacy plays out in case of investments in the stock market:
About a year ago in Dec 2017, Rahul bought a few stocks of Vakrangee Ltd. at Rs.400 per stock. One month later, news reports came regarding corporate governance issues in the company and the company’s share price declined significantly to Rs 160. Rahul holds on to the stock since he had invested a huge amount in it.
But later Rahul consults his friend who is a long time successful investor. Based on the falling profits and clear information regarding serious issues with respect to corporate governance practices in the company, his friend suggests him to sell the stock because there is no way that the price will bounce back. The friend further goes on to explain that this erroneous thinking of holding the stock just because you paid a higher price is because of the sunk cost fallacy.
Sunk Costs are the costs (maybe money or time) that are incurred irrespective of the decision we take and they cannot be recovered. Sunk cost fallacy is the tendency where the investors tend to hold on to the stock, though the price of the stock keeps falling.
The initial investment made to acquire the stock or the losses incurred till now should not influence our decision of selling or holding on to the stock. Attempting to recover the sunk costs is like getting further trapped in losses. Instead, the focus should be on the comprehensive fundamental analysis of the investment’s future prospects. One should analyze where the amount invested will deliver better returns in the future rather getting stuck with losses.
As Peter Lynch famously said “Selling your winners and holding your losers is like cutting the flowers and watering the weeds”
The concept is also very eloquently explained by Rolf Dobelli in the video below. Do check it.