Behavioural economists have a name for this tendency of people and organisations to stick with a losing strategy purely on the basis that they have put so much time and money into it already. It’s called the “sunk cost fallacy”.
Let’s say a couple buy a property next to a freeway, believing that planting trees and double-glazing will block out the noise. Thousands of dollars later the place is still unlivable, but they won’t sell because “that would be a waste of money”.
This is an example of a sunk cost. Despite the strong likelihood that you’ll never get your money back, regardless of outcomes, you are reluctant to cut your losses and sell because that would involve an admission of defeat.
It works like this in the equity market too. People will often speculate on a particular stock on the basis of newspaper articles about prospects for the company or industry. When those forecasts don’t come to pass, they hold on regardless.
It might be a mining stock that is hyped based on bullish projections for a new tenement. Later, when it becomes clear the prospect is not what its promoters claimed, some investors will still hold on, based on the erroneous view that they can make their money back.
The motivations behind the sunk cost fallacy are understandable. We want our investments to do well and we don’t want to believe our efforts have been in vain. But there are ways of dealing with this challenge. Here are seven simple rules:
These are simple rules. But they are all practical ways of taking your ego out of the investment process and avoiding the sunk cost fallacy.
There is no single perfect portfolio, by the way. There are in fact an infinite number of possibilities, but based on the needs and risk profile of each individual, not on “hot tips” or the views of high-profile financial commentators.
This approach may not be as interesting. But by keeping an emotional distance between yourself and your portfolio, you can avoid some unhealthy attachments.