What Every Trader Needs To Know About Sunk Costs

By January 12, 2018featured, Trader Tips
What Every Trader Needs To Know About Sunk Costs

There’s an adage in the neuroscience community that goes like this: “We know more about space than we do about our own brains!”

That must be amusing to those neuroscience peeps because there is a whole lot of stuff we don’t know about space, and a whole lot more we don’t know about the brain.

Our brain’s subconscious workings are difficult to outline in the scientific process. We all have mental biases that exist under the radar, hidden underneath our sense of free will and the pile of information like the names of our favorite restaurants in a five-mile radius.  There’s just so much we don’t get.

But we do know some things.  Large-scale studies with hundreds to thousands of participants have been conducted with the purpose of bringing valuable data on human behavior and brain function to the table. In order to be incorporated into a theory, the highest honor any piece of information can attain in the modern scientific world, the results need to be replicable as well. 

The result of these cognitive studies is that we gain a bit more insight into the intricate workings of our brain, which can help us understand our actions, our decision-making abilities, what drives us, what demotivates us, etc.

Knowledge of these cognitive theories—and there are many of them—are a critical aspect of trading.  It can change the game for traders who are smart enough to recognize their own vulnerabilities and clever enough to exploit the vulnerabilities of others.  One particularly important cognitive theory is sunk cost bias.  It can either be your friend if you understand it, or your enemy if you don’t.

 

What are sunk costs?

Sunk costs are costs—measured in either time or money—that have already been incurred and that cannot be recovered.

Let’s say you have a broken lawnmower.  You need a new blade, and you pick one up at a garage sale for $5.00.  Because it’s a garage sale item, you know you can’t return it if you get it home and realize it’s the wrong one.  You get home only to find out its for a newer model.  Your $5 is a sunk cost—you can’t get it back, and now you have to buy another blade at the parts store for $15. 

The trap in sunk costs is this: The weight of spent resources is so heavy that it keeps you from moving on to a more profitable venture.  In this overly simplistic scenario above, your sunk cost bias would tell you that because you spent $5 on a blade for the wrong lawnmower, and you’re already out that expense, that now you have to buy the correct model of lawnmower to utilize the blade.  Yeah… sounds dumb, but in many circumstances, this is EXACTLY how our brains work.

It’s easy to see with a small amount of $5 in sunk costs versus $250 that would need to be spent to make that $5 count again.  But what if the numbers were different?  What if the lawnmower blade cost $250?  Does your thought process about your next move shift?

Part of this bias has to do with how we think about sunk costs.  We so desperately want to undo it.  To make it count! Even if it’s illogical numerically speaking, we will keep throwing good money after bad, to keep the “bad” from being “bad”.   

Let’s face it:  People just don’t like the idea of losing money, and often will make irrational decisions to keep from losing money—even if it means spending more.

Research shows that traders and others alike tend to believe that spent money is more valuable than money still in the pocket. This is, of course, untrue. Empirically speaking, any dollar in your bank account holds the exact same value as any dollar you have already invested. Other than relative liquidity, there is literally no difference between the two.

It’s the same with time. The hour I just spent writing this article for your reading pleasure is no more valuable than the hour I could pass later tonight by watching the next episode of American Horror Story. Time is constant in value, though it could seemingly be going faster or slower depending on how badly you need it.

But this sunk cost trap lowers cognitive agility by blinding the mind to the opportunity costs of completing a boring movie, forking away at an entirely tasteless meal, or keeping old clothes. These things do not please us now and will not benefit us in the long run, but try telling that to yourself next time you make at attempt to clean out your closet.

The sunk cost trap is also known as the “Concorde fallacy”, which refers to a failed supersonic jet program that the British government insisted on completing, even though trial after trial showed the project had no future in which the jet would be satisfactorily functional.

Smart traders know when to cut their losses, and when to look forward.

Let’s look at another example:

Stanley reads about a “hot” new stock in one of his favorite investor magazines. He decides to use $1,000 of his hard-earned savings to buy some shares, but a year later the value of the funds has dropped to just $200 despite an upswing in the market overall and rising stock values in comparable companies.

The smart move in this case would be to pull out that money and invest in another up-and-coming venture. Instead, Stanley sticks to the old stock, which he has inexplicably lobbed onto, and just a weeks later, his shares lose all value.

 

Sad story, huh? This happens all too often. Perhaps not to this extreme, but in a close enough rendition to cause hundreds or thousands of dollars in losses.

Digging in with sunk costs can keep you from making necessary changes to your trading strategy. Repeat after me: Throwing good money after bad is… bad.

To avoid the sunk cost trap, make sure to consider only future costs and returns, rather than weighing yourself down with the guilt of knowing there is no way your previous decision will bear any fruit. Take the negative feedback and do something about it in the present so that you can have a better outcome in the future.

 

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Learn to measure marginal costs and benefits, to track any added value that can be derived from further actions. If no such value exists, get out.

Big corporations with hierarchical leadership chains understandably have difficulty steering clear of the sunk cost dilemma.

A mid-level manager tasked with heading a major internal project sees an unsurmountable roadblock ahead. If the project goes uncompleted, the company loses the thousands its already invested in it, potentially causing the manager’s supervisor to doubt his or her abilities.

Personal consequences tied to an incomplete end result compound the effects of this bias, causing large institutions to lose sight of their brakes and keep hitting the gas pedal.

But stock brokers generally have more autonomy. This is especially the case for traders working part-time to make ends meet.

There’s no one to impress, besides yourself, so focus on the end goal and be flexible on the way there. Make mistakes, realize them, forgive yourself for them and get on the next one.  

 

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