Chapter 13

We cannot change the past (the sunk cost fallacy)

Between 1988 and 1993 the Australian stock market swung upward and downward in a sideways pattern. This has happened again between 2009 and when I am writing this book in early 2013. Markets that swing up and down in a generally sideways pattern are the most difficult markets for active private investors to manage. When markets are rising consistently, investing is easy: active private investors buy good stocks and hold them, switching out of any non-performing stocks as necessary. It should be just as easy when markets are falling consistently: active private investors sell any stocks that are not performing and sit in cash. However, when markets go generally sideways with significant up and down swings, even quite experienced active private investors come under real pressure to follow their investment plan and to act on stop-loss levels faultlessly.

Of course, passive investors have few decisions to make, but they suffer considerable unrealised losses of capital and reduced income through the downward phases in the market cycle. This can be disastrous if they have to sell investments at the wrong time for living expenses.

As we saw in the previous chapter, successful active investors should have learned that one of the keys to high returns is to let profits build and to cut losses quickly. They are ruthless in quickly selling investments that fail to unfold as they expected. On the other hand, if an investment begins to pan out as they thought that it would, they will prudently build on their initial position and show great patience in allowing the investment the time needed to meet their expectations.

The disposition effect showed that this is diametrically opposed to what most novice investors do quite naturally. It is far more common to see tyro investors losing money because they do the exact opposite. If an investment they make begins to show good results, they usually snatch small profits quickly and miss out on even bigger gains. This is bad enough in terms of the opportunity missed, but when things go wrong beginners are most likely to freeze and to be unable to cut their losses, which grow ever larger as they ride the stock downwards.

This is one of the many ways in which the best investors have learned to think in opposite ways to the natural instincts that we all start out with as we begin the journey from novice to master as investors. It is a big subject, which is discussed from the viewpoint of several cognitive biases. For now, we will focus on one of the most important aspects in which the best investors excel over the novices: dealing with investments that go off the rails. Warren Buffett famously said that his first rule is never to lose money. His second rule is to never forget the first rule. This is how important this great investor believes it is to avoid losses, and he is not alone among the greats. The irony that escapes many beginners, though, is that the counterintuitive way to avoid losses is to accept them. If we take the loss from a bad investment while the loss is still small, it can’t go on to become a much larger loss, which is unfortunately what often happens.

The reasons why most people find it difficult to make the decision to cut a losing investment are complex. One of the more interesting is what Richard Thaler described in 1980 as the sunk cost fallacy. It is one of the more important reasons why investors ride losses rather than making a more rational decision.

Sunk cost is a well-established idea from economics. It is a cost that has been incurred, but which is no longer recoverable. Where the sunk cost fallacy comes in is when the unrecoverable cost is used mentally to drive an irrational decision. At some time everyone will have seen the sunk cost fallacy in action without realising it.

Jason and Dianne bought their house 10 years ago for $450 000. Since then, their family of four children has outgrown the house so they need more bedrooms. Jason has also changed his job and now works a long way from where he lives. The time lost, and the expense incurred in travelling to and from work have started to get Jason down. He would dearly like to move closer to his work, which would also suit Dianne, who would be closer to employment as she rejoins the workforce. They put the house on the market, but after many months the best offer they receive is $410 000. Their real estate agent argues this is the market rate. Even though Dianne wants to accept the offer and move on, Jason is adamant that he will not sell their house for $410 000 when he paid $450 000 for it. He digs his heels in on that point alone and they take the house off the market. They commission an extension to the house and Jason and Dianne are doomed to expensive, long and tiring journeys to and from work for many years. They have made an irrational decision because of the sunk cost fallacy.

The way to see past the sunk cost fallacy is this: money that has already been paid is a sunk cost. It relates to the past. It has gone and the transaction cannot be magically reversed. The rational way to deal with such a situation is to assess the options that are now possible. For Jason and Dianne the two most obvious options were either to take the price at which the market was now valuing their house and move to a new suburb near Jason’s work, or to stay put, extend the house and suffer the cost and inconvenience of travelling. Clearly, the first was the better option, as demonstrated by their desire to put the house on the market so they could move. What blocked the rational decision was when Jason became stuck on the original cost of their house — the sunk cost that was not a relevant consideration, because it related to a different market at a different time.

In investing, the original price paid for a stock is a sunk cost. If the stock falls in price over time, there is no certainty that the sunk cost can ever be recovered. The sunk cost fallacy comes in when an investor is reluctant to make a rational decision to take a loss on the stock because the current price is less than when the investment was first made.

Most of us will have heard this reasoning and even used it ourselves in the context of investing or of various other aspects of life. It comes up almost any time people have a choice of continuing on a bad course or cutting their losses by changing course.

To avoid the sunk cost fallacy as investors, it is necessary for us to change the way we think about the situation. We have to accept deep down inside us that nothing we do today or tomorrow, no decision we make now or in the future, will ever change something that has happened in the past. The only thing we can do is to affect what happens from now on. We can never change the past, but we can affect the future.

What we paid for a stock is a sunk cost. It is gone. What we now have is a tranche of stock that is only worth what we can sell it for. It is seductive to imagine that if we just sit out the loss, the price may go back to what we paid and we can then sell and get out even. This is the most common and utterly natural way most people think. It is the sunk cost fallacy writ large. It also ignores opportunity cost, which was discussed in the previous chapter on the disposition effect and prospect theory.

Yes, it is possible that the price may rise again in the future. It is equally possible that the price will continue to fall. In fact, a chartist will tell you that if the stock is in a downtrend, it is more likely to continue to fall than to rise, because trends tend to persist. Savvy investors also have a rule about bad news: it tends to keep coming for quite a while before things get better.

The solution lies in changing the way we think about losing investments. We have to list the options open to us, which are:

1 Hold on, hope and pray until we get our original investment back.

2 Sell and switch into a better investment opportunity.

3 Sell and sit in cash awaiting a better investment opportunity if there is not one available at the moment.

Options 2 and 3 are the rational decisions. Option 1 is the sunk cost fallacy in action. There is no law that says we must make up a loss the same way we incurred it. We can recover from a loss in a non-performing investment by switching into a better investment. We may even do better than make up our loss in another stock because we may earn better dividends in the process.

Here is another, albeit extreme, way to grasp this point. Suppose that I held a gun to an investor’s head and gave her a choice to sell the loss-making investment or be shot. She would now see only two options and make the rational choice. What I would have done here is to force the investor to ignore the sunk cost, which is what she paid for the losing investment. Even in the highly unlikely event that she thought about it for a moment, it would not seem at all important just now.

If I then invited the investor to make a choice between buying back that same stock or buying some other stock, she would most probably now make the rational decision to consider all of the alternatives, free of the sunk cost fallacy.

The rational investor should work at developing a habit of forgetting the sunk cost and focusing at all times on the full range of alternatives open: to continue, to switch or to liquidate.

Perhaps we should give Warren Buffett the last word. He once reminded an audience of an old saying that if we find ourselves in a hole, the smart thing is to stop digging. Richard Thaler would add: and start to consider all the alternative ways out of your predicament.

Summary

The sunk cost fallacy arises when we make an irrational decision in the present because we are fixated on a cost that we have incurred in the past, rather than take the best option that is now open to us. We cannot change the past; it is done and gone. However, we can select an optimal course for the future.

The first step in dealing with the sunk cost fallacy is to be aware of it and how destructive it can be in terms of poor investing decisions.

Strategies

The best strategy to deal with the sunk cost fallacy in investing was described in the previous chapter for the disposition effect. This is to conduct a regular review of our portfolio after each reporting season. This review process is best done as a formal written report, because it makes it more difficult to push losers out of our mind and not consider the other options that we have. Identify the non-performers and make a search for and evaluate several alternatives compared with the existing non-performing holdings. This will highlight the opportunity cost of continuing to hold the non-performers, taking our attention away from the sunk cost. Then it will be easier to make the switch because we are focusing on the best way to use the value that is in the non-performers, rather than what we invested in them, part of which is gone. We do not have to make it back the way we lost it. In fact, we are likely to do even better if we switch into a superior stock.