What You Need to Know About The Sunk Cost Effect & Trading
A close relative of loss aversion is the sunk cost effect (or bias), where traders refuse to exit loss making positions because they think that doing so would be “wasting” the amount lost.
4. Sunk Costs
From a more general standpoint, the sunk cost effect applies to any situation where someone makes a decision based on what has already been spent, rather than the implications for the future.
This covers a wide spectrum of decisions, from corporate investment decisions to personal ones. In the former, the sunk cost effect manifests itself when managers choose to stick to a course of action because of how much it cost.
For example, a company doggedly electing to upgrade a $20 million legacy IT system that no longer suits their needs, instead of investing in a completely new IT system.
It is evident that the sunk cost effect is clouding decision making when you hear arguments such as “but we’ve already spent $20 million on the old system”, and/or “but we’ve spent countless hours learning to use and work with the old system”.
However, neither the $20 million, nor the amount of time already spent on the old system has any relevance to whether or not the legacy system can meet the corporation’s future needs.
That’s what makes the sunk cost bias so dangerous, it keeps our minds locked on the past instead of focusing on the future.
In the context of trading, the sunk cost bias shows up most commonly in making decisions to exit positions with a small, but manageable loss. For example, our hypothetical stock trader who went long AAPL at $145, has a decision to make when the stock falls to $142 – take a small loss, or hold on in hopes of a future rally?
Take a moment to put yourself in his shoes and think: what would you do if you were him?
If you were focused on the $3 per share loss and felt like exiting the position would be “wasting” that money, since no one knows if the stock will or won’t recover, then your decision has been clouded by the sunk cost effect.
The key here is to consider the future – if AAPL goes up again then all is fine, but what if it doesn’t?
The $3 loss can very quickly grow into a $5 loss, then a $10 one; and before you know it, your entire trading account is at risk.
What’s worse is that the larger the loss gets, the more entrenched the sunk cost bias becomes – if you were unwilling to “waste” $3, would you be willing to “waste” $10?
The sunk cost bias also compounds with loss aversion, making it even more difficult to cut your losses as they grow larger; since you’re now unwilling to make the loss real and “waste” the capital and time invested in the trade!
Fortunately, all it takes to guard against the sunk cost bias is a little discipline. As with all other cognitive biases and their negative effects on trader’s decision making processes, the solution is a simple one – construct a trading plan with clear risk management parameters and stick to it.
Unfortunately, this is easier said than done, as many professional and retail traders learn at some point in their trading careers.
What ultimately separates the profitable from the unprofitable is not a magic crystal ball, but consistency in executing a well constructed trading plan.
It doesn’t sound sexy at all, but it’s what works.
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