Sunk Cost Fallacy: Why You Shouldn't Go Down With The Ship

August 8, 2016

Have you ever sat through a terrible movie because you paid the ticket price? Or finished a book because you reached the halfway point before realizing it was garbage?  If so, you’ve fallen for the sunk cost fallacy.

The sunk cost fallacy is the idea that you should continue to do something undesirable due to the fact that you have already invested time or money.  It’s a fallacy because once the initial expenditures have already been made, you cannot get them back regardless of whether or not you finish the activity.  A rational human would cut their losses and move on to something with greater potential returns. Sadly, you’ve already wasted time reading the first half of a worthless novel but why waste more?  You can put down the book and invest your time in learning to invest or spending time with your friends and loved ones yet many of us (myself included) will often go down with the ship and unhappily reach the end.

The history of the stock market is rife with investors who fell prey to the sunk cost fallacy and lost everything.  Consider the case of Blockbuster, the original Netflix that required people to drive to a dedicated video store to rent movies.

Blockbuster (formerly BBI – NYSE)

Let’s say you are an inexperienced investor who buys 100 shares of Blockbuster stock in November 2004 after the company hits a 52-week low (thinking now it has to go up!).  Over the next eight months the price increases but never comes close to the previous 52-week high. In less than one year you realize that the stock price has fallen below your purchase price, you’ve lost money!

The problem is that now you’re suffering from the sunk cost fallacy and no matter what, you won’t sell the stock at a loss.  It has to go back up and you don’t want to lose money and miss out after holding it for a year! Instead of increasing in price though, the stock stabilizes below your purchase price for years before bottoming out in bankruptcy in 2010. You’ve lost everything!

Instead of going down with the ship, an experienced, rational investor would have re-assessed their investment and potentially sold their stock at a loss to move the unproductive funds to something new.  While nobody likes to sell at a loss, a small pain in the short-term will likely be much better than a long, drawn-out destruction of capital in a dying industry. Investors can also use their losses to offset taxes on their successful investments which can net-out the pain almost completely.

Now you ask, what if it goes up right after I sell for a loss?  This will happen to every investor over the course of their life.  A prudent investor will make the best decision possible given a combination of the available information and their personal balance between expected risk and return.  At the same time, even the best, most rational investors can still be wrong. Professional baseball players only hit the ball 30% of the time so you don’t need to be perfect to be successful.

That being said, it is important to understand WHY you purchased every stock in your portfolio and WHY you should continue holding it.  One of the keys to successful investing is remaining rational in the face of changing information. Don’t overreact to short-term losses if you believe in the long-term fundamentals of the firm and industry and don’t go down with a sinking ship due to the sunk cost fallacy.