Psychology and Investing: Sunk Costs

Sunk cost fallacy is another factor driving loss aversion.

This theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

Our inability to ignore the sunk costs of poor investments causes us to fail to evaluate the situation on its own merits.

Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses.    

[?Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.]

****Every decision has to be taken on the basis of the factors present in the situation right NOW

Sunk Costs

One key to understanding how the past affects the present is the concept of 'sunk costs'.  This refers to the tendency to allow past investments or expenditure to affect decisions in the present.  Even though every decision has to be taken on the basis of the factors present in the situation right now, the pull of past events can be very strong.

We need, wherever possible, to see decisions in terms of future benefit rather than past losses or gains.  But we are often more likely to choose alternatives that are in line with our past spending rather than changing direction, because we don't like the idea that past investment is 'wasted', and wish to redeem it.  This can lead us into the trap of 'throwing good money after bad', or 'honouring' sunk costs.

What has been invested need not be financial, or even tangible.  In fact, we may feel a far stronger 'pull' from emotional investmetns than financial ones.  For example, we might wish to continue with a project because of the time we have put into it and the attention we have lavished upon it, even though it has become clear that the probability of success is far lower than we had thought.  The problem is that we have 'put something of ourselves into it'; to give up on it now is to give up on a part of ourselves.  Obviously, these feelings are a long way from objective decision making.