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Beware of the sunk cost fallacy ...

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Cassandra   Tuesday, 09/03/13 01:12:59 PM
Re: Cassandra post# 3
Post # of 18 
Beware of the sunk cost fallacy ...

The Fallacy of Sunk Costs

By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: November 19, 2012

Have you ever seen someone spend an inordinate amount of money on a carnival game in an effort to win an inexpensive prize? If you have, then you have seen the sunk cost fallacy in action. People will often spend a lot to win an inexpensive prize because the human mind is not inclined to rationally evaluate sunk costs. Participants often think that, if they don’t win the prize, the money they have spent on the game will have been “wasted,” and continue to play. This phenomenon flies in the face of traditional microeconomics, which holds that people act rationally and only allow future costs to affect decisions. Behavioral finance, on the other hand, blends the study of economics and psychology to offer important insight into the sunk cost fallacy.

Bias Against Admitting Failure

Investors fall victim to the sunk cost fallacy when they allow the purchase price of a stock to dictate when the stock is sold. The tendency of investors to sell winning stocks too early and hold onto losing stocks too long has been well documented. Many investors don’t consider a poorly performing investment a failure until they sell the stock and realize the loss, and as a result investors are much more likely to sell winning stocks than they are losing stocks. There are two main problems with this approach. The well documented “momentum effect” whereby stocks that have recently gained are likely to continue gaining for at least a short while, works against investors that sell winners. Additionally, holding losing stocks is very inefficient with regard to taxes because capital losses can be used to offset tax liabilities.

Worse yet, some investors try to turn a losing investment around by “throwing good money after bad,” which can have devastating consequences when they increase their position in a poorly performing stock that continues to fall. This is sometimes referred to as trying to “catch a falling knife.” Admitting failure isn’t easy, but sometimes it’s the least costly way out of a poor investment.

The Sports Fans’ Dilemma

One of the best examples of the sunk cost fallacy is provided by Richard Thaler, a pioneer in the field of behavioral economics.

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 more likely to brave the blizzard to see the game?

You instinctively know the answer - the fan that paid for his ticket is more likely to brave the blizzard. A rational individual would not care whether or not the ticket had been purchased or received as a gift. It is only worth the expected enjoyment of attending the game minus the expected costs of bracing the storm. The ticket itself is a sunk cost because it can’t be returned, and that sunk cost should not enter into the decision to attend the game. The reality, however, is that not attending the game will be more emotionally difficult for the fan who paid for his ticket since he has to deal with the disappointment of not seeing the game as well as the sunk cost of the ticket. The mind has a tendency to classify such an outcome as a “double fail” that should be avoided, so the fan who paid for his ticket will be more likely to drive into the blizzard. With the proper perspective and discipline, however, the fan could instead ask, “Would I still drive into the blizzard if the ticket was free?”1

Know When to Fold ‘Em

One of the terms often used when people use sunk costs to justify irrational decisions is the poker term “pot committed.” People often say they are “pot committed” to fix something old, like a car, because they have high sunk costs that would go to waste if they “threw in the towel” and bought a newer car. In fact, only future costs should matter. Such a decision should only be based on expected future repair costs, utility derived from reliability, utility derived from pride of ownership, and replacement costs (minus depreciation).

Inexperienced poker players often think of themselves as “pot committed” if they have sunk a lot of chips into a pot and they continue to call future raises even if they have little or no chance of winning. On the other hand, experienced poker players understand that being “pot committed” has nothing to do with sunk costs. Instead they analyze the size of the pot, and will only feel “committed” to make a call when the pot is very large relative to the cost of the raise. The only factors that should matter are the cost of the bet, the odds of winning, and the size of the pot. It doesn’t matter where the money in the pot came from – whether the money is the bettor’s own money or from the bets of other players is irrelevant.

The sunk cost fallacy can adversely affect your investment returns if you are not careful. When you find yourself dwelling on the price you paid for an investment, ask yourself what you would do with the investment if it were gifted to you. The same perspective can be applied to cars or equipment in need of repair. And if you need help preventing sunk costs from affecting your personal finances, consider consulting a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association with the experience and expertise necessary to guide you.

FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.


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