What is the sunk cost trap?
The sunk cost trap is when people tend to irrationally stick to activities that do not meet their expectations. This is because they have invested time and/or money. The sunk cost trap explains why people watch movies they don’t like, eat bad meals, keep clothes they’ve never worn in their closets, and hold underperforming investments. The sunk cost trap is also known as the Concorde fallacy, due to the failure of the supersonic Concorde jet program, which funding governments insisted on completing despite the jet’s poor prospects.
How the sunk cost trap works
Investors fall into the sunk cost trap when they make decisions based on past behavior and not wanting to waste the time or money they have already invested rather than cutting losses and making decisions that will give them the best possible outcome in the future. Many investors are reluctant to admit, even to themselves, that they made a bad investment. Changing strategies is seen as an admission of failure, perhaps subconsciously. As a result, many investors tend to stay committed, or even put extra money into a poor investment to make their initial decision seem worthwhile.
Examples of sunk cost traps
Jennifer purchased $1,000 worth of Company X stock in January. In December, the value of the overall market and similar stocks had fallen to $100, even though the value of the overall market and similar stocks had risen over the course of the year. Instead of selling the stock and putting the $100 into another stock that might appreciate in value, she holds shares in Company X, which will become worthless in the next few months.
Avoid the sunk cost trap
The best way to avoid the sunk cost trap is to set investment goals. To do this, investors can set performance goals for their portfolios. For example, investors might seek a 10% return from their portfolio over the next two years, or have a portfolio outperforming the S&P 500 by 2%. If a portfolio fails to meet these goals, it can be reassessed to see where improvements can be made for better returns.
If an investor is trading individual stocks, they can have a pre-determined exit point before entering the trade. This helps automatically reduce losing positions and avoid investing more time and money on ineffective investments.