The sunk cost idea is sinking your investments

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The tendency to not recognise losses is accompanied by a willingness to recognise profits.

In some ways, the dilemma of equity investors is what to do with those investments that turn out to be losers. I remember being told by a fund manager that “I bought well, but I did not sell well.” It’s a common complaint. The problem here is of admitting one’s mistakes, which is a difficult thing to do for almost everyone. The tendency is always to go on pretending that some miracle will happen and we will not have to recognise that we picked a loser.

It’s been 15 years since the psychologist Daniel Kahneman was awarded the Nobel Prize for Economics, an event which introduced the phrase ‘behavioural economics’ to a lot of people. Kahneman is known for his work on the psychology of judgement and decision making, fields which have a natural connection to behavioural economics, and the psychology of investors. In 2011, Kahneman published ‘Thinking, Fast and Slow’, which laid out his ideas in a highly accessible form. The sunk-cost problem is introduced in the book thus, “Two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket; the other was on his way to purchase a ticket when he got one free from a friend. A blizzard is announced for the night of the game. Which of the two ticket holders is likely to brave the blizzard to see the game?” We know the correct answer: the fan who paid for his ticket will be more determined to see the match because ‘he has more to lose’. However, we realise the flaw in it. The money is already gone. Taking the risk of driving in a snowstorm will not get it back.

We could transplant this situation to equity investing. One investor buys a stock at a lower price and another buys it at a higher price after it has gone up. Soon, the stock starts declining and it comes down to roughly the price at which the first investor had bought it. Now we are in roughly the same situation as the baseball fans. The first investor can sell off without any notable loss or profit, while the second one can only sell out if he’s willing to bear a loss. The second investor is likely to hold on to the dud investmentbecause he has a loss. The first one is likely to sell out because doing so will not involve a loss. The irrational part is that the future is the same for both, and only the past is different. The money used to buy the stock is gone. The only question is whether you can recover any remaining value, before that too is lost.

However, in investing, there is an opposite effect too . The tendency to not recognise losses is accompanied by a willingness to recognise profits. Investors hang on to their winners and sell out losers. That’s the worst thing that one can possibly do to one’s investments. Unfortunately, it’s also one of the commonest. Everyone does it.