What is Sunk Cost Fallacy?
The Sunk Cost Fallacy is a cognitive bias in behavioral finance where investors have a tendency to continue a strategy because of their reluctance to forego the capital, time, and effort invested to date.
What is the Definition of Sunk Cost Fallacy?
The sunk cost fallacy is a concept in economics and behavioral finance that refers to a common decision-making bias that causes investors to continue with an underperforming investment strategy.
The term “sunk cost” is defined as the losses already incurred and thus cannot be recovered. The losses mentioned in the prior statement can consist of 1) monetary costs and 2) non-monetary costs.
- Monetary Sunk Costs → The capital losses incurred by the firm on the investment and the fees paid (e.g. brokerage fees).
- Non-Monetary Sunk Costs → The resources committed to date as part of the investment process, most notably the time spent researching the target and the effort exerted to analyze the investment.
The act of adjusting an investment strategy and accepting the incurred losses requires admitting the original decision might have been incorrect or otherwise untimely, which is an inevitable aspect of investing in the stock market.
Oftentimes, investors are reluctant to admit – even to themselves – that a past investment and the underlying thesis was “wrong”.
Therefore, the sunk cost fallacy is a cognitive bias where investors are reluctant to abandon their current strategy if a substantial amount of capital, time, and effort has already been invested.
Why? The investor allocated a significant amount of capital, time, and effort into the investment – so, instead of taking a step back to regroup and adjust as deemed necessary – the “knee-jerk” reaction is a refusal to accept that the original thesis might have been incorrect.
The decision-making process of an investor can become tainted by the accumulated emotional attachment to the investment, because the more resources are invested, the more challenging it becomes to abandon the idea.
Evaluating the Sunk Cost Effect (Source: ScienceDirect)
What Causes the Sunk Cost Fallacy?
The sunk cost fallacy, or “sunk cost effect” is predicated on the premise that committing to the current investment strategy is justified because resources like capital and resources like time have already been committed to the plan.
The decision to alter an existing investment strategy and adjust an investment portfolio is subconsciously a form of admitting failure (and being incorrect), which is what sets the foundation of the sunk cost fallacy.
Hence, the pattern of behavior among retail and institutional investors, where the investors remain committed – or perhaps even end up investing more capital into the investment that caused losses – is all in an effort to prove the initial investment thesis and decision was in fact “correct” and a worthwhile bet.
The decision to accept that the strategy did not work, and the best course of action is to cut the losses and move forward is challenging, but it is a critical skill to master for disciplined, long-term investors.
The sunk cost fallacy is closely tied to the concept of “loss aversion”, “status quo bias”, and “optimism bias”.
- Loss Aversion → Under the specific pretense of investing, loss aversion describes the cognitive bias where investors perceive losses asymmetrically – namely, more negatively relative to equivalent gains. In simple terms, the weight of monetary losses is substantially more taxing mentally relative to monetary gains of equivalent value.
- Status Quo Bias → Status quo bias is a behavioral pattern relevant to investing that causes investors to be reluctant to change their investment strategy and reverse course on their past decisions. Because of the status quo bias, investors possess the tendency to maintain the status quo, i.e. a preference for continuation of the current strategy and reluctance to accept the need to adjust the investment strategy and plan going forward.
- Optimism Bias → The optimism bias is based on an investor’s tendency to overestimate the odds that their efforts will eventually bear fruit, which effectively causes red flags to be ignored. The reasoning to continue pursuing a project or investment is because the investor has convinced themselves that with time, the plan will pay off. The decision is rooted in self-belief, instead of objective analysis and analytical research. Thus, the investor willfully decides to ignore the recent underperformance based on the belief that over time, the market – which from the investor’s perspective is wrong – will correct itself and that the favorable outcome will come to fruition.
How Does Sunk Cost Effect Work?
The sunk cost fallacy is a pitfall that investors must remain congnizent of and avoid because the cognitive bias can cause irrational behavior that deviates from the core principles specific to an investor.
For example, an investor that incurs steep losses in their portfolio might continue to re-invest in the stock and “double-down” on the investment, without any type of hedging techniques to mitigate the risk of continued losses.
In effect, the investor is more likely to act more irrationally because of the recent losses and employ more aggressive tactics to recoup the losses.
- Positive Outcome → The post-loss, aggressive investment strategies to recoup losses could perhaps play out in the favor of the investor over time.
- Negative Outcome → The other outcome, on the other hand, is the loss of even more capital (and commitment of more non-monetary resources). Therefore, the investor has essentially dug themselves into an even deeper hole of total monetary losses.
Upon suffering substantial losses, fear often sets into the investor’s mental state – which is frequently amplified by market participants keeping close tabs on the moves of hedge funds – causing reckless decision-making for undisciplined investors, i.e. criticism from equity analysts and the media can cause the investor to become prone to falling into the sunk cost fallacy trap.
The investors that fall into the sunk cost trap are usually those that base their investment decisions on past behaviors and a strong desire to not lose the capital invested and time allocated towards the investment. This is done in lieu of cutting their losses and making the rational decision that would improve the odds of the best outcome going forward, so as to avoid a temporary hit to their ego and reputation.
Therefore, rather than learning from the poor performance of the investment and questioning the original investment thesis, the investor’s decisions are based on emotions, which seldom results in a positive outcome.
Sunk Cost Fallacy Investing Example
For instance, suppose the value of a hedge fund’s portfolio increased by 5.0% in the prior month.
If the portfolio value had declined by 5.0% instead in the preceding month, the incurred loss would be far more psychologically impactful on the investor – irrespective of the gain (or loss) being of equivalent value.
Therefore, the positive emotions tied to the 5.0% gain are not comparable to a 5.0% loss, as the latter scenario is far more taxing on the emotional state of the investor.
Simply put, a loss of $100k is far more likely to influence the psychological state and decision-making process of an investor in comparison to gaining $100k.
How to Avoid Sunk Cost Bias in Investing?
So, how can investors avoid falling into the trap of the sunk cost fallacy?
- Acceptance of Reality → Absolutely no investor – not even the top performing fund managers – is correct all the time, yet many refuse to accept that. The reluctance to admit that the investment thesis could potentially be wrong (or mistimed) is often the source of a downward spiral in risky investment decisions, so the removal of the emotional attachment to the strategy, detaching from the ego related to the need to be right, and the willingness to adjust is the first step.
- Objective Analysis → Starting from scratch, the investor should conduct a detailed diligence to determine if the original strategy is based on sound judgment and logic. Instead of referencing the initial thesis and supporting models, the better approach is to truly detach and perform the analysis as if the investment were a new potential investment opportunity. The analysis should be conducted using the latest financial and market data available using a systematic process for performing diligence based on the investment criteria of the firm.
- Cost-Benefit Analysis → Understanding the trade-off between cutting one’s losses and sticking to the original investment is critical for an investor to not fall into the “trap” of the sunk cost fallacy, which is particularly important for institutional investors that invest on behalf of their limited partners (LPs). In short, “Is the potential upside worth the costs and resource commitments?” If not, in all likelihood, it would be best to just accept the losses and move onward. The opportunity cost of capital (and time) must be closely considered here.
- 3rd Party Opinion → The opinion of a 3rd party, such as a consultant or trusted advisor experienced with investing in the public markets, can be useful to grasp a better understanding of the situation. The 3rd party advisor does not carry the same bias as the investor, so their independent opinion is valuable as part of performing an in-depth objective analysis on the best course of action.
- Hedging Techniques and Portfolio Diversification → The act of adjusting one’s portfolio does not necessarily mean cutting all losses and removing the investment. But rather, the adjustments could include portfolio diversification as a risk mitigation strategy to counterbalance the chance that the investment strategy might not pan out as intended. However, portfolio diversification and hedging tactics can mitigate the risk of incurring further capital losses.
Sunk Cost Fallacy Example: Melvin Capital and GameStop (GME)
Led by Gabe Plotkin – a former trader at SAC Capital (now Point72) and protégé of Steven A. Cohen – Melvin Capital was widely recognized in the industry as a top-performing hedge fund before the short-squeeze that caused the fund to eventually liquidate.
From 2014 to 2020, Melvin Capital generated annualized returns of around 30%. But the strong return profile took an unanticipated turn for the worse after the short-squeeze from the “meme stock mania” around 2021.
In 2022, Gabe Plotkin announced his plans to wind down Melvin Capital after suffering losses in excess of billions of dollars. Melvin never recovered from the short squeeze of GameStop (GME) in 2021, garnering irreparable reputational damage among the retail investing crowd.
Plotkin had soon become the “face” of the institutional investment firms that retail investors on the subreddit, r/wallstreetbets, targeted and viewed as opportunistic vultures that unfairly preyed on companies that the firm held short-positions on.
In particular, GME was one of Melvin Capital’s most bearish bets – not to mention, the short position was highly levered – yet, retail investors came together to support GameStop (GME), with the stock price surging close to 2,500% (and peaking at $483 per share) at the start of 2021.
The outcome? Melvin lost around $7 billion in January 2021.
By the end of January 2021, Plotkin closed the short position at a steep loss, and the returns of the hedge fund were around negative 39% to close out the year.
“I now recognize that I need to step away.”
– Gabe Plotkin, Letter to Shareholders
Of course, the internal decision-making process and firm’s commitment to challenge the retail investors is not publicly available information, so much of our commentary here is based on pure speculation.
However, it would be safe to presume that Melvin underestimated the risk posed by retail investors banding together, and Plotkin certainly did not seem to expect retail investors to identify Melvin’s short positions in their 13-F filings to further damage the firm’s returns alike the GME short-squeeze.
In closing, the hypothetical question to ask here is, “Where would Melvin Capital currently be if the firm had admitted defeat earlier on, cut their losses, and backed out of the fight with retail investors?
In addition, “Why did Melvin Capital not defend the role of short-selling in the financial markets, as part of a PR strategy, and step back upon realization that the threat from retail investors presented a material risk?”
Many of Melvin Capital’s adjustments, such as covering its outstanding short-positions in Q1, were made far too late – i.e. after incurring billions in losses.