What is Sunk Cost Fallacy?

The sunk cost fallacy is a cognitive bias where individuals or organizations justify continuing a project or investment based on the resources they have already sunk into it, rather than the marginal cost/benefit of the next dollar. In other words, it’s the tendency to “throw good money after bad” because of the sunk costs that have already been incurred.

Sunk Cost Fallacy in Investing

An example of the sunk cost fallacy might involve an investment in a struggling company. Despite the company’s continued poor performance, the investor may continue to invest additional capital to turn the business around even when outsiders determine it’s a poor investment.

For instance, imagine an entrepreneur invests in a software company. After a few years, the company’s sales have been much lower than expected, and the firm realizes that their technology is not as promising as they initially thought. At this point, the investor has already sunk a significant amount of money into the project, including hiring and training employees, purchasing manufacturing equipment, and developing the technology.

Despite the poor performance of the company and the negative outlook for the technology, the investor may decide to continue investing in the business to try to recoup some of the sunk costs they have already incurred. They may invest more money in R&D, hire additional staff, or spend more on marketing to try to boost sales.

However, this decision is based on the sunk costs that have already been incurred, rather than the potential for future gains or losses. Investors may continue to invest in the struggling company, even though it is unlikely to generate a positive return, simply because they have already sunk so much money into the project.

In this example, the sunk cost fallacy can lead investors to make irrational decisions and waste additional resources, rather than cutting their losses and moving on to more promising investment opportunities.

The sunk cost fallacy is a cognitive bias that can have serious implications for investors.

Chasing Losses: A Common Trap for Investors

Chasing losses is a common way that investors fall victim to the sunk cost fallacy. When investors experience losses, they may feel compelled to keep “doubling down” to recoup their losses. This can lead to a vicious cycle of throwing good money after bad, as investors become increasingly “pot committed” to their investments.

Loss Aversion: The Fear of Letting Go

Loss aversion can also come into play when investors are faced with losses. The fear of losing money can cause investors to hold onto investments that are no longer viable, rather than cutting their losses and moving on. This can be a dangerous trap, as it can lead investors to throw good money after bad.

Emotional Attachment: Letting Go is Hard to Do

Another way that investors can fall victim to the sunk cost fallacy is by becoming emotionally attached to an investment. When investors become emotionally invested in a stock or other investment, they may be unwilling to let it go even when it no longer makes sense to hold onto it. This can lead to irrational decision-making, as investors may be more concerned with saving face than with making the best decision for their portfolio.

How to Avoid the Sunk Cost Fallacy in Investing

So how can investors avoid falling victim to the sunk cost fallacy? Most importantly, it’s important to recognize that sunk costs are just that – sunk. They’re in the past, and there’s nothing you can do to change them. Instead of focusing on what you’ve already invested, focus on what you stand to gain or lose going forward.

It’s also important to be willing to cut your losses when necessary. If an investment is no longer viable, it’s better to sell and move on than to throw good money after bad. And finally, don’t let your ego get in the way. We all make bad decisions from time to time, but it’s important to learn from our mistakes and use our experience to become better decision makers.

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