The sunk cost fallacy refers to the tendency to continue an endeavour or make decisions based on past investments (time, money, effort) rather than considering the future costs and benefits. This fallacy occurs when people make decisions by factoring in costs they’ve already incurred (sunk costs), even though these costs should not influence future choices.
In the stock market, the sunk cost fallacy can occur in several ways:
1.Holding onto losing stocks:
Investors may hold onto stocks that are declining in value because they’ve already invested a significant amount of money into them. Instead of cutting their losses and selling, they continue to hold, hoping the stock will recover simply to justify their previous investment.
Example: You buy shares of a company for $100 per share. Over time, the stock price drops to $50. Instead of selling to minimize further losses, you hold the stock because you’ve already spent $100 per share, and you don’t want to “lose” that amount.
2.Chasing bad investments:
Some investors might keep adding more money into a stock or a portfolio that has underperformed, reasoning that they need to average down their cost to break even. This can lead to even larger losses, especially if the company or investment is fundamentally flawed.
Example: An investor keeps buying more shares of a stock that has already lost substantial value in hopes of lowering their average purchase price, thinking that the stock will bounce back.
3.Missed opportunities:
Investors may hold onto bad investments for too long because of emotional attachment to the initial investment, missing better opportunities elsewhere. They might feel that selling would make their past decision feel like a failure, even though the better choice would be to reallocate the capital into more promising stocks.
Why does the sunk cost fallacy matter in the stock market?
Emotional bias: The emotional attachment to previous investments clouds judgment, leading to decisions based on emotions rather than rational evaluation.
Poor decision-making: Investors may ignore the fact that past costs are irrecoverable and should not influence current decisions. The focus should instead be on future potential returns, not past losses.
Reduced portfolio performance: The sunk cost fallacy can lead to holding onto poor-performing stocks or missing better investment opportunities, which can drag down overall portfolio performance.
Overcoming the sunk cost fallacy in the stock market:
Focus on future potential: Make investment decisions based on future growth potential or fundamental analysis, not past performance.
Set exit strategies: Establish clear criteria for when to sell a stock, such as price targets or changes in the company’s fundamentals, to avoid making emotional decisions based on past investments.
Learn to cut losses: Recognize that it’s better to realize a loss and invest the capital in more promising opportunities than to keep hoping for a recovery in a bad investment.
By staying objective and recognizing the sunk cost fallacy, investors can make more rational and profitable decisions in the stock market.
Lauren Hua is a private client adviser at Fairmont Equities.
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