We’ve all been there. You poured your heart (and your money) into a stock or business venture, only to see it flounder. The urge to “hold on” can be strong, fueled by the fear of admitting defeat and the belief that things will eventually turn around. But clinging to a losing investment, driven by the sunk cost fallacy, can be a costly mistake.
What is the Sunk Cost Fallacy?
The sunk cost fallacy is the tendency to continue investing in something – using money, effort, or time – simply because you’ve already invested a significant amount. This can happen even when it’s clear that further investment is unlikely to yield good returns.
Why is it so hard to let go?
- Emotional Attachment: You might feel an emotional connection to your investment, and particularly one that you felt strongly about. This can make it difficult to accept that it might not succeed.
- Fear of Loss: The fear of losing money already invested can be a powerful motivator to hold on, even when it looks like future losses could grow.
- Ego: Admitting failure can be a blow, making it difficult to accept that you might have been wrong. Vindication of your judgment can become your major focus, rather than earning a good financial return.
- Inflexibility of Standards: A good baseball slugger will get a hit three out of ten times at the plate. Similarly, how should you judge if you’re a good investor? Perfection can’t be the standard.
When to Think Hard About Cutting Your Losses
- If Your Goal is to “Break Even”: You need to consider if this is an informed business decision or mostly a desire not to lose face or meet an unattainable standard. Time-proven investors, like Warren Buffett, don’t worry about admitting a mistake. They embrace these, knowing that their experiences can help them make good decisions in the future. Alternatively, hoping for your eventual vindication can lead to even further losses.
- If the Investment Premise Keeps Changing: You may have committed money based on a different scenario than what is being discussed (or pitched) today. You should evaluate the investment as if you are seeing it for the first time.
- If You Speculated, Rather Than Invested: If you bought an asset with the hope that it would soon become more valuable, rather than performing an evaluation focused on the long term (like a part owner of a business would do), it’s a good time to consider whether you were right. Speculation usually involves thinking that you’re one of the first to recognize an opportunity. If, over time, others aren’t coming to the same conclusion, it’s possible that you are wrong.
- If Your Strategy is that Others Will Follow Your Lead: Hoping that there will be other people who will come along and “buy you out” of your holding is not a position of strength. Your strategy has changed from finding a good investment to enticing a likely buyer.
- Alternative Opportunities: If you have more promising investment opportunities available, it may be more beneficial to reallocate your resources.
Overcoming the Sunk Cost Fallacy
- Acknowledge the Past: Recognize that your past investment, regardless of its outcome, is a sunk cost and don’t allow this to influence your present decision.
- Focus on Future Potential: Evaluate an investment based on its future prospects, and not its past performance.
- Practice Discipline: Develop the discipline to cut your losses when necessary, even if it’s emotionally difficult.
- Seek Objective Advice: Consult with a trusted financial advisor or mentor for an unbiased perspective. We appreciate it when our clients discuss these things with us.
Conclusion
While it’s natural to want to make back your losses, clinging to a bad investment based on the sunk cost fallacy can be a costly mistake. By acknowledging the past, focusing on future potential, practicing discipline, and seeking objective advice, you can make more informed investment decisions and maximize your long-term returns. As always, call us if you’d like our input.
Disclaimer: This article is for informational purposes only and does not constitute specific financial advice.
Eric Ball, CFA
Managing Director
America First Investment Advisors, LLC
Omaha, Nebraska
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.
