People are emotional beings. Unfortunately, this means that people sometimes make irrational decisions based on the way they feel –– and not based on sound logic or principle. Indeed, even very smart individuals sometimes let their emotions cloud their judgement. And the bad news in this regard is that even one investing mistake can end up costing you serious amounts of capital. With that in mind, today we’ll explore the sunk-cost fallacy and explain what it is and how new investors can ensure they never fall into this trap themselves.
What are Sunk Costs?
In simple terms, sunk costs are expenses that an individual cannot recover. For example, if you pay to have bunion surgery, you won’t be able to recoup the cost of the procedure. In investing terms, sunk costs refer to capital outlays that an investor is unlikely (or unable) to make back. Sunk costs happen all the time because plenty of investments don’t produce profits or dividends. Note here that making a bad investment doesn’t make you a bad investor. The reality is that all entrepreneurs occasionally lose money investing.
What is the Sunk-Cost Fallacy?
While sunk costs are an unfortunate but essentially an inevitable part of investing, the sunk-cost fallacy is a detrimental behavior that can derail even the most cautious investors. At its most basic level, the sunk-cost fallacy can be summed up as throwing good money after bad. When an investor continues to pump money into a business, stock, or venture that does not produce profits, they are engaging in the sunk-cost fallacy. Worse, the more emotionally-tied to an investment an individual is, the more likely they are to continue to gamble on a bad investment. This is why seemingly reasonable people may make the mistake of putting more money than they can afford into a poor business investment.
How to Avoid the Sunk-Cost Fallacy
The first step to avoiding the sunk-cost fallacy in your own life is to learn about it. Knowing that your emotions can cause you to make poor investment decisions is a key element to the psychological aspect of investing and trading. Of course, diagnosing when other people engage in the sunk-cost fallacy is easier than identifying it in your own behavior. That’s why it’s a smart idea to have a few safeguards against the sunk-cost fallacy in place. A few tips on this matter include:
- Capping your investments. Don’t invest more than you can afford to lose.
- Predetermining cut-off points. Once an investment reaches a point of no return, cut your losses.
- Speaking with others. Trusted financial advisors and even friends and colleagues may be able to tell you when you’re engaging in a bad investment strategy.
At the end of the day, no investment plan is perfect. Recognizing this now, and knowing when to call it quits, can save you a lot of money and plenty of stress in the years to come.