Imagine two scenarios.
Scenario 1: You are looking to watch that latest Hollywood action flick you’ve been waiting for the past six weeks. Going by the pre-release popularity of the movie, you’ve had to pay Rs 500 per ticket, which is almost 3 times the normal price.
However, you are excited for the movie so the cost doesn’t pinch you that much. Now, just a day before your show, a couple of your friends who’ve already watched the movie tell you that it’s not worth watching at all. The hero’s acting is poor, and the story is very predictable and boring.
What do you do? You’ve already spent Rs 1,000 for a couple of tickets for you and your wife.
Scenario 2: You are looking to watch the same movie and have been lucky to get complimentary passes from your club. But just a day before your booking, you hear bad reviews about the movie and that it’s not worth spending three hours on.
What do you do? You’ve got the complimentary passes, which only a few people have received.
If you are a normal-thinking person, you’ll still go and watch the movie in the first scenario, when you paid for it from your own pocket.
However, in the second scenario, you would want to skip the show as it was anyways ‘free’.
Behavioral scientists call such behavior as…
The ‘sunk cost fallacy’
The ‘sunk cost fallacy’ states that we are unable to ignore the ‘sunk costs’ of a decision, even when those costs are unlikely to be recovered.
So if we’ve spent money on something that we later realise wasn’t worth it, we continue to hold it close to our hearts.
Let’s look at another example, this time from an investor’s perspective.
You’ve bought a stock at Rs 100 after doing a lot of research on it. You’ve studied the company, its products, competitors, and its management. In all, you’ve spent a lot of time in identifying the stock before buying it.
Going by your highly positive view on the stock, you’ve invested Rs 5 lac in it.
However, in one month after you bought the stock, it falls to Rs 80 and your total investment value comes down to Rs 4 lac. You know it is a temporary fall, as the company continues to do well.
The stock falls further to Rs 60. Your investment value is now just Rs 3 lac, down 40%. You start to panic. But you still hold the stock tight. After all, you know you did your research well and thus continue to maintain your faith in the stock.
In the meanwhile, there’s news of the company looking to exit some of its profitable businesses and the stock falls further to Rs 50.
You start to hate it. But you still don’t want to sell. You don’t want to get rid of it. Even if you realise later that buying the stock was a mistake as the company’s management was known for making bad decisions.
Your reaction is…
“It’s now too late! I’m already down 50%. Now I don’t want to convert the paper loss into real loss by selling the stock. And then, I spent so much time and energy finding this stock. Let me wait for some more time for it to come back to my cost price and then I’ll surely sell.”
So you end up with a situation where just because you have put a lot of time and energy into the selection of the stock, even when you realise that you must sell it, you are afraid to cut it loose.
It’s the ‘sunk cost fallacy’ at work here. Most investors fall into this trap and lose a lot of money by just staying invested in bad stocks, or good stocks that turn bad.
Now imagine if you hadn’t bought this falling stock but had received it as a gift from your father. In that case, perhaps you wouldn’t have hung on to it quite so long.
Just get over that sinking feeling
Learn to walk away from bad decisions you made in the past.
You see, we all make financial mistakes. But when you realize you’ve done something wrong, try not to think about the money (and time and emotion) you’ve already spent. Instead, decide what to do based on the present and the future.
So, don’t think how much you lost given your investment value fell from Rs 5 lac to Rs 2.5 lac. Think what you can do with Rs 2.5 lac now so that it grows back to Rs 5 lac. And staying with a stock that’s not going to take you there isn’t the right choice for you.
In Why Smart People Make Big Money Mistakes and How to Correct Them, the authors write:
“Once your money is spent, it’s gone. It has no relevance. To the extent you can incorporate that notion into your financial decisions, you’ll be that much better off for trying. If you’re debating the sale of an investment (or a home), for example, remember that your goal is to maximize your wealth and your enjoyment. The goal is not to justify your decision to buy the investment at whatever price you originally paid for it. Who cares?
What counts, in terms of getting where you want to be tomorrow, is what that investment is worth today.”
So, just get over that ‘I can’t quit’ trap.
Your sunk cost is already sunk in the past. Now, don’t sink your future worrying about it.
Instead take a leaf from the mistake, and get on the path to becoming a smarter investor.