1) Your family has tickets to a basketball game, which you have been looking forward to for a very long time. The tickets are worth $100. However, on the day of the game, a big snowstorm hits their area. Although you can still go to the game, the snowstorm will cause a hassle that will certainly reduce the pleasure of watching the game. Are you more likely to take your family to the game if you purchased the tickets for $100 or if the tickets were given to you for free?
a) I am more likely to attend the basketball game if I paid $100 for the tickets.
b) I am more likely to attend the basketball game if I was given the tickets for free.
2) You have long anticipated going to the basketball game, which will take place next week. On the day of the game, a snowstorm occurs. Are you more likely to take your family to the game if you purchased the $100 tickets one year ago or yesterday?
a) I am more likely to attend the basketball game if I purchased the $100 tickets a year ago.
b) I am more likely to attend the basketball game if I purchased the $100 tickets yesterday.
Traditional economic theories predict that people will consider the present and future costs and benefits when determining a course of action. Past costs should not be a factor. Contrary to these predictions, people routinely consider historic, non-recoverable costs when making decisions about the future. This behavior is called the “sunk cost” effect. The sunk cost effect is an escalation of commitment and is defined as “the tendency to continue an endeavor once an investment in money, time or effect has been made.” Sunk costs have two important dimensions; size and timing. Now let’s review your answers to the question above.
The common belief is that you are more likely to go to the game if you had purchased the tickets. Note that the $100 cost of the tickets does not factor into the hassle of the snowstorm or the pleasure derived from the game. Yet most people consider the sunk cost in their decision whether to go or not.
A family that pays for the tickets opens a “mental account.” If they do not attend the game, the family is forced to close the mental account without the benefit of the purchase, resulting in a perceived loss. The family wishes to avoid the emotional pain of the loss; therefore, they are more likely to go to the game. Had the tickets been free, the account could be closed without a benefit or a cost.
The first example illustrates the size of the cost as a significant factor in decision-making. In both cases, you already had the tickets, but it was the cost of the tickets ($100 versus $0) that mattered. However, in the second example, it was the timing of the sunk cost that was an important factor.
In both cases, the $100 purchase price is a sunk cost. However, does the timing of the sunk cost matter? Yes, a family is more likely to go to the game if they purchased the tickets yesterday than if they purchased the tickets last year. The pain of closing the mental account without a benefit decreases with time. In short, the negative impact of a sunk cost depreciates over time.
The “sunk cost” effect is the very same factor that affects many investors’ decision-making today. For example, often an investor will choose an individual stock that has all of the right prospects that you would look for in a big winner, but the stock’s price does not follow their expectations. It’s ok; it happens. However, it is how the investor handles the situation following these developments that can make all of the difference in a portfolio.
At a certain point in the stock’s decline in price, many investors will just write it off as a “sunk cost” and hope that the stock bounces back, versus simply “getting out” before the losses become too steep. If you were to add in the factor of timing, as the example listed above, then the “sunk cost” effect becomes even more prevalent. Rather than just accepting a small 8%-10% loss (because the investor is hoping the stock will bounce back), the investor then watches the stock decline 20%, 50%, and so on. At some point in this decline, many investors will realize their mistake of not getting out when the loss was still small, and will mentally accept the current much larger loss as a “sunk cost” in hopes that the stock comes back.
Whether or not you have ever exhibited the behavior detailed above, it is simple to see how a structured, risk-controlled system can help investors to make better decisions with their money. While some seasoned investors may consider the “sunk cost” effect to be a “rookie mistake,” even the most experienced investors can make a wrong decision; which can be very costly. The key to investing is to take a proven, structured approach and avoid the behavior detailed above. Additionally, the key to growing any portfolio is simply to ride the winners and cut your losers while they are still small.
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