The Fallacy of Sunk Costs

Real conversation happened between the client ( Mr. A) and Pentagraph Advisors ( PA )  in year 2009.

 Background: 

Mr. A had invested Rs. ‘m’ in NFO at the face value of 10 and the current value is Rs 5 in Mid 2009 .

 Conversation:

PA : Sir , you should book losses in this fund as it was sold to you during Bull period of              07 – 08 and it is sectorial based fund .

 Mr. A : No , it is 50 % loss . I will exit when it reaches 10 again .

 PA : So , you think , it will reach 10 again .

Mr.A : Yes ,Market seems improving.

 PA : We think you should then invest more in it if it is going back to Rs 10.

Silence for a minute and then topic got changed to other investments.

It is nothing but Sunk Cost Fallacy .

Investors fall victim to the sunk cost fallacy when they allow the purchase price of a stock/MF to dictate when the stock/MF is sold. The tendency of investors to sell winning stocks/ MFs too early and hold onto losing stocks/MFs too long has been well documented. Many investors don’t consider a poorly performing investment a failure until they sell the stock/MF and realize the loss, and as a result investors are much more likely to sell winning stocks/MFs than they are losing stocks/MFs.

In economics, a sunk cost is any past cost that has already been paid and cannot be recovered. For example, a business may have invested  1 cr into new hardware. This money is now gone and cannot be recovered, so it shouldn’t figure into the business’s decision making process.

It happens in our day to day life . People often fall prey into the Sunk Cost Fallacy Trap.

Let’s say you buy tickets to IPL match . On the day of the match, you catch a cold and fever. Even though you are sick, you decide to go to the IPL match because otherwise “you would have wasted your money”.

Boom! You just fell for the sunk cost fallacy.

Now , let’s say the IPL ticket was gifted to you , then it is not the Sunk Cost and you may decide to stay home and take rest .

Lot of investors fall victim to the sunk cost fallacy because they have emotionally invested the money in the past.

The sunk cost fallacy can adversely affect investor’s investment returns if they are not careful. When investor finds himself dwelling on the price he paid for an investment, he should ask himself what he would do with the investment if it were gifted to him.

Benjamin Graham, Father of Value Investing, nicely quoted in his book ‘The Intelligent Investor’

“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”