Sunk cost bias is a cognitive bias that influences decision-making by placing undue emphasis on the resources (time, money, effort) already invested in a particular endeavor, even when those investments are irrecoverable or ‘sunk’. It leads individuals to continue investing in a project or course of action based on past investments, rather than objectively evaluating the current and future prospects.
The key characteristic of sunk costs is that the costs cannot be recovered, regardless of the decision made going forward. However, individuals affected by the sunk cost bias often consider these costs as relevant factors in their decision-making process. They may feel compelled to persist with an investment or project to avoid feeling that their initial investment was wasted or to justify the effort and resources already expended. It can play out in investing in the following ways:
- Holding losing positions: Investors may hold onto losing positions for longer than they should due to the sunk cost bias. They might continue to hold onto a stock or security that is declining in value, hoping for a rebound to recoup their losses. This behavior can result in further losses if the trade continues to move against them, as they are basing their decisions on past investments rather than current market conditions.
- Doubling down on losing trades: In an attempt to recover from losses, investors influenced by sunk cost bias may increase their position size or add to losing trades. They do this to reduce the average cost per share or contract in the hope that a subsequent price move will enable them to break even or turn a profit. However, this strategy can amplify losses if the trade continues to go against them.
- Ignoring new information: Investors may become resistant to new information or changing market conditions if it conflicts with their existing positions. The sunk cost bias makes them reluctant to abandon their initial trade or course of action, even if there are clear indications that the market has shifted. They may cling to their original analysis and disregard new evidence, leading to missed opportunities or further losses.
How to overcome the sunk cost bias?
So, what are the ways to alleviate the impact of this behavioral bias? There are three things that can be done to address it: focusing on current market conditions, setting clear exit strategies, and being prepared to continually adapt.
- Focus on current and future market conditions: Investors should base their decisions on current market conditions, technical analysis, and fundamental factors rather than dwelling on past investments. They should evaluate trades based on their current potential for profitability and adjust their positions accordingly.
- Set clear exit strategies: Investors should establish predetermined stop-loss levels or profit targets for each trade. These levels should be based on objective factors such as technical analysis, risk-reward ratios, and overall trading strategies. By adhering to these exit strategies, investors can limit losses and avoid the temptation to hold onto losing positions or add to losing trades based on sunk costs.
- Continual evaluation and adaptation: Investors should be open to new information, adjust their course of action as market conditions evolve, and reevaluate their positions regularly. This flexibility and willingness to adapt can help investors avoid being trapped by sunk costs and enable them to make decisions based on the most relevant and current market dynamics.
By consciously recognising and mitigating the influence of sunk cost bias, investors can make more rational, objective, and adaptive decisions in their trading activities. The problem, of course, is that it is easier said than done, so a systematic and disciplined approach is crucial here to make it work.