You ordered an expensive meal at a fancy restaurant. You get a huge portion. You eat until you’re full, but there’s still food on your plate – food you’ve already paid for. You’re not hungry, but you feel like you have to finish your dish.
Why keep eating? You’ve already bought it, so you feel as though you have to finish the meal. “ It would be a waste not to eat it,” your brain reminds you. That type of thinking is known as the “sunk cost trap.”
In economics, a sunk cost is a cost incurred in the past that cannot be recovered. It’s money already spent. It’s also a cost that should have no influence on the next decisions you make.
The sunk cost trap causes us to justify a bad decision today based on a non-recoverable expense from the past that no longer has any bearing. We don’t like to change our minds and make a new, more informed decision – because we subconsciously feel that would mean our first decision was a failure. We keep soldiering on, hoping the situation reverses in our favour.
That type of thinking is harmless enough in a restaurant, but it often creeps into our investment decisions, and that is not good.
Imagine you invest $5,000 in a company’s shares, to buy 100 shares at $50 per share. Six months later, the share price has dropped to $30. The rational decision would be to follow your trailing stop level, and sell the stock.
Instead, because you’ve already spent $5,000 on the shares – now worth only $3,000 – you decide to hold on.
Worse still is doubling down on the stock and buying more at the lower price. Again, you may do this to persuade yourself that your initial decision was a good one. In reality, it’s a desperate attempt to recover losses.
We previously discussed the example of Noble Group. After it reached S$2 a share, the stock lost 80 percent of its value. To break even would require a staggering 400 percent gain. How likely is that? It could be very damaging if “sunk cost thinking” caused you to believe the stock would recover.
What we said then applies here: don’t wait for the market to rebound. Instead, if the market starts to fall, sell the stock when the price drops to a pre-established level. We recommend using a trailing stop, where you determine the price at which you would sell as a percentage below the market price.
Keep that as a mental target, but make sure you remain disciplined and sell as soon as the market hits your stop level. That will help you to minimise the potential damage from the sunk cost trap.
Also, remember to invest like a psychopath. Don’t let emotions get in the way of your decisions. In this case, don’t look back, or your mind will be swayed into agonising over how much you spent on that losing stock.
In this way, you will be able to limit your losses and avoid being dragged down further. Don’t get trapped in sunk costs.