The reasons why most people find it difficult make the decision to cut a losing investment are complex. Possibly the most interesting one is what Richard Thaler described in 1980, as the sunk cost fallacy - It is a cost that has been incurred, but which is largely not recoverable.
The way to see past the sunk cost fallacy is this: Money that has already been paid is a sunk cost. It relates to the past. It has gone and the transaction cannot be magically reversed. The rational way to deal with such a situation is to assess the options that are now possible.
In investing, the original price paid for a share is a sunk cost. If the share falls in price over time, there is no certainty that the sunk cost can ever be recovered. The sunk cost fallacy comes in when an investor is reluctant to make a rational decision to take a loss on the share because “the current price is less than I paid!”
To avoid the sunk cost fallacy as investors, it is necessary for us to change the way we think about the situation. We have to internalise that nothing we do today or tomorrow, no decision we make now or in the future, will ever change something that has happened. The only thing we can do is to affect what happens from now on. We can never change the past, but we can affect the future. What we paid for a stock is a sunk cost. It is gone.
The solution lies in changing the way we think about losing investments. We have to list the options open to us, which are:
1. Hold on, hope and pray.
2. Sell and switch into a better investment opportunity.
3. Sell and sit in cash awaiting a better investment opportunity if there is not one available at the moment.
Options two and three are the rational decisions. Option one is the sunk cost fallacy in action.
The rational investor should work at developing a habit of forgetting the sunk cost and focusing at all times on the full range of alternatives open: to continue, to switch or to liquidate.
Perhaps we should give Warren Buffett the last word: The most important thing to do when you find yourself in a hole is to stop digging. Richard Thaler would add: and start to consider all the alternative ways out of your predicament.