What is the sunk cost fallacy? The idea that any money or time you already spent on a thing matters.  That money is gone.  That time is gone.  You shouldn’t let the time or money you spent on a bad idea keep you from throwing the bad idea away.  Preferably far away.

This comes up all the time.  People finish terrible movies because they spent $10 to buy the ticket, rather than walking out of the theater and enjoying the rest of their evening doing something more interesting.  This isn’t a very big deal with a movie, you lose, what, another hour or so?  However, the effect is significant and unfortunately seems to become stronger when the stakes get higher.

Like in Investing?

Yup, the sunk cost fallacy is all over the place in investing.  The major danger here comes from anchoring. No, this has nothing to do with newscasters.

Sunk-cost-2

When you initially buy a stock, people often get anchored to the price they paid for it (in investing parlance, your cost basis).  If the price then, gets cut in half, or doubles they think about the new stock price relative to what they paid for the stock. This is exactly wrong.

What you paid for a stock should not enter into your analysis.  It is a sunk cost. It might matter for your tax considerations, but if you own a company that is intrinsically worth $5 per share, that’s what it is worth.  The only factors in your decision making should be the intrinsic value of the shares, and the market price of the shares.

This seems obvious, but some of the earliest mistakes I made investing were related to this.  The first stock I ever invested really heavily in was Safeway.  They were making money hand over fist compared to the price of their shares, management was using that money to buy-back shares at a breakneck pace.  It didn’t take a genius to figure out that something good would happen.

still me

still me

Not being a genius, I bought a significant amount at $15 per share.  It went up a little bit, to $20 per share, and even though the company was still cheap relative to it’s intrinsic value, I sold, thinking I had made a great profit.

The nutty thing about this is that if I had discovered the opportunity a 3 months later I would have bought it at $20 per share, but I was so focused on what I paid for the stock that the higher market price got me excited to sell.

The stock proceeded to get bought out for $30+ shortly later.

There is another side to this too, I had a friend that bought Microsoft at roughly $35 a few years ago.  It proceeded to drop between $5 and $10, I don’t remember exactly how much.  It concerned him a great deal to be “losing money” on the trade.  It stayed low for a few months or a year, and then went back up to $35.  He was so excited once the stock was back at what he paid for it, that he sold immediately.

What he didn’t take into account was that Microsoft was then making even more money than when he originally bought the stock!  As of this writing Microsoft trades at $65, and has paid out a substantial amount in dividends as well.  (I make no recommendation about Microsoft).  Had my friend not been so focused on his sunk cost and instead focused on the business, he would have nearly doubled his money.

Dealing With It

This bias is extremely powerful and it’s hard not to feel that stocks that have gone up since you’ve bought them are somehow better than stocks that have gone down.  Unfortunately, when deciding what you should keep in your portfolio what you paid for a stock (outside of tax considerations) shouldn’t matter to you at all!  You should be only focused on whether the stock is more likely going to go up or down in the future not what it did in the past.

How do I deal with this?  Use a broker that hides your cost basis from you.  If you don’t remember what your cost basis is, it can help prevent you from making bad decisions because of your cost basis.  For this I like Loyal 3, but they have a very limited selection of stocks that they’ll trade.

Unfortunately the bottom line here is that this is dangerous knowledge.  Simply knowing it makes it more likely that you will do worse in the market.

 

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