Investing can be an emotional journey, especially when you’ve put significant time, effort, and money into a particular asset. The sunk-cost fallacy is a common psychological trap where investors continue holding onto losing investments simply because they’ve already invested so much, and it’s too difficult to walk away. Recognizing and avoiding this fallacy is a must, though, for making rational, profitable investment decisions.

Let’s go over a few ways that you can prevent yourself from falling into this trap.

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Understanding the Sunk-cost Fallacy

The sunk-cost fallacy occurs when people make decisions based on past investments rather than future value. In investing, this means an individual might hold onto underperforming stocks, funds, or assets, simply because of the amount of money they’ve already put into the investment.

For example, if you purchased a stock at $100 per share and it has dropped to $50, the sunk-cost fallacy would push you to keep holding onto it with the hope of recovering losses, even if the stock’s fundamentals have deteriorated. Emotional attachments like these often lead to further losses instead of informed decision-making.

The key to overcoming the sunk-cost fallacy is to redirect your focus from past losses to future potential. Ask yourself, “Would I buy this stock at its current price today?” If the answer is no, then holding onto it simply because you already own it may not be the best strategy.

Why Investors Fall for the Sunk-cost Fallacy

Several psychological and behavioral biases contribute to this fallacy, including:

  • Loss Aversion: Studies show that people feel the pain of losses more intensely than the pleasure of gains. This bias leads investors to hold onto failing investments in an attempt to avoid realizing a loss.
  • Commitment Bias: Investors often want to justify their past decisions and avoid admitting to mistakes they’ve made. Remember, we all make mistakes, and sticking with a poor investment longer than you reasonably should isn’t going to change that fact.
  • Hope and Optimism Bias: The belief that a bad investment will eventually recover can cloud rational judgment. While optimism is an important component of investing, it should be grounded in data, not wishful thinking.
  • Fear of Regret: Selling at a loss can feel like failure, which causes investors to delay making a decision, just hoping that the market will turn in their favor.

Strategies to Avoid the Sunk-cost Fallacy

Most fallacies are easy to fall into, and the sunk-cost fallacy is no different. This sort of mindset isn’t obvious at first, but by the time you take notice, the value of your investment is often unrecoverable.

To prevent experiencing the sunk-cost fallacy, try:

Setting Up an Exit Strategy

Before making any investment, define clear criteria for selling. Establish stop-loss orders or price targets based on reliable financial analysis rather than emotions. This way, you remove the need for emotional decision-making when the market fluctuates.

For example, you might decide in advance that if a stock drops 20% below your purchase price and there’s no fundamental reason to hold it, you will sell.

Reevaluating Your Investments

Regularly assess your investments based on current data, market conditions, and company performance. Ask yourself: Would I invest in this today at its current price? If the answer is no, consider cutting your losses and reallocating funds to a better opportunity.

It’s also a good idea to compare your investments against other opportunities in the market. If your capital could generate better returns elsewhere, sticking with a losing investment is not a financially wise decision.

Separating Your Emotions from Investments

Detach yourself emotionally from investments. Treat them as business transactions rather than personal achievements. Understand and accept that making mistakes is part of the investment process, and exiting a bad investment is a sign of discipline and wisdom, not failure.

Diversifying Your Portfolio

A well-diversified portfolio reduces the emotional impact of any single investment. If one stock performs poorly, it won’t feel like such a devastating loss, because others will likely be performing better. Diversification helps mitigate risks and keeps you focused on long-term financial goals instead of individual stock performance.

Learning from Experience

Recognizing when you’ve fallen into the sunk-cost fallacy can help you avoid it in the future. Keep a journal of your investment decisions, including why you made them and how they turned out. Reviewing past mistakes helps develop better decision-making habits.

Seeking Professional Advice

Sometimes, an outside perspective can provide the clarity you need for making smart financial decisions. Financial advisors or experienced investors can help you assess whether an investment still holds value or if it’s time to move on.

Focusing on Opportunity Cost

Instead of dwelling on past losses, think about where your money could work more effectively. If you’re holding onto a bad investment, you’re missing out on better opportunities. Always compare your current investment choices with potential alternatives.

For example, if you are holding onto a stock that has lost significant value and has weak future prospects, you might consider allocating that capital to a stock with strong growth potential. By doing so, you ensure your money is always put to its best use.

The sunk-cost fallacy is a psychological roadblock that many investors struggle with, but overcoming it leads to more rational investment decisions.

Remember, successful investing isn’t about being right all the time. Instead, it’s about making decisions that maximize your returns in the long run. Recognizing and avoiding the sunk-cost fallacy is one of the most important skills an investor can develop. By focusing on future potential rather than past losses, you position yourself for long-term success in the financial markets.

 

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PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. All investments involve risk, including the loss of principal.