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“It’s okay to be wrong, it’s not okay to stay wrong”. Maybe you’ve heard some variation of this saying before? It’s one of my favorites, as it applies nicely to all facets of life, especially investing. A common reason many of us decide to “stay wrong”, rather than change, is the sunk cost fallacy.
The sunk cost fallacy is another behavioral heuristic caused by loss aversion. If you’ve forgotten, loss aversion refers to our human desire to avoid losses at all costs. Losing hurts more than winning feels good, and this can greatly affect the decision-making process. After we make a decision to invest in something, it becomes increasingly difficult to abandon it, even if it would be rational to do so. Some of this has to do with overconfidence bias (we all think our decisions are intelligent and superior to those of others), and the rest has to do with the sunk cost fallacy.
Josh Brown of Ritholtz Wealth Management has this to say regarding the sunk cost fallacy:
“The Sunk Cost Fallacy keeps you in error, it steals the most precious resources you have at your disposal – opportunity and time. It’s poisonous, identify it and cut it out sooner rather than later.”
Have you ever sat through an awful movie simply because you paid to see it? We’ve all been there before. You hand over your hard earned money to see a movie, and thirty minutes in you’re wondering why you bothered. How many of us actually get up to leave the theater? Because of the sunk cost fallacy, most of us would rather continue wasting our time watching a bad movie than concede we made a mistake.
Do you regularly finish all of your food at restaurants despite being full half way through the meal? You probably feel guilty “wasting” that food you paid for. Instead of leaving the remainder on your plate, you decide to completely stuff yourself and finish every last bite. You’re consuming unnecessary calories and potentially putting your health at risk over the guilt of feeling wasteful.
Is there a stock in your portfolio that you refuse to sell, even though you’ve lost exorbitant amounts of money in it? Many investors are reluctant to sell positions they have large losses in. Maybe they bought it for double what it’s worth now. Instead of cutting their losses and putting their money into a more appropriate investment or using it for something else, they continue to hang on in hopes that they’ll be “proven right” some day. Even worse, maybe they throw good money after bad and continue investing while the stock keeps plummeting.
Even sports teams suffer from this behavioral bias. How many times have you seen a team cling to a former first round draft pick for no apparent reason? They get chance after chance to prove themselves because of their high pre-draft pedigree, but expectations never come to fruition. James Surowiecki of The New Yorker wrote about my beloved New York Jets and their relationship with Mark Sanchez in this light. As painful as it was to realize this behavioral mistake on their part, it’s an excellent example. You can see that the sunk cost fallacy doesn’t only affect individuals, it strikes on the organizational level as well.
The common theme here is that the sunk cost fallacy affects us when our original investment is something that we can’t get back. Your investment can be money, time, resources, a first round draft pick, or anything of value. Instead of realizing that our original cost is fixed and in the past, we continue to weigh it in our decision-making process for the future. In fact, we tend to overweight the original cost and forget about the future cost of perpetuating our mistakes.
Don’t remain wrong because of poor decisions. You have a choice to either continue making the same mistake or change your ways. Ben Carlson of A Wealth of Common Sense refers to this as our ability to, “hit the reset button”. This usually involves swallowing pride and being open to new ideas/concepts. You may not be able to get your original investment back, but the future is yours for the taking. Don’t let the sunk cost fallacy keep you wrong.