Have you ever made yourself suffer through a bad movie because, having paid for the cinema ticket, you felt you had to get your money’s worth? Some people treat investment the same way.
Behavioural economists have a name for this tendency of people and organisations to stick with a losing strategy purely on the basis that they have put so much time and money into it already. It’s called the “sunk cost fallacy”.
It works like this in the share market too. People bet on a particular stock on the basis of articles about prospects for the company or industry. When those forecasts don’t come to pass, they hold on regardless.
The motivations behind the sunk cost fallacy are understandable. We want our investments to do well and we don’t want to believe our efforts have been in vain. But there are ways of dealing with this challenge. Here are seven guidelines:
- Accept that not every investment will be a winner. Stocks rise and fall based on news and on the markets’ collective view of their prospects. That there is risk around outcomes is why there is the prospect of a return.
- While risk and return are related, not every risk is worth taking. Taking big bets on individual stocks or industries leaves you open to idiosyncratic influences like changing technology. Remember Kodak?
- Diversification can smooth the path. Over time, we know there is a capital market rate of return. But it is not divided equally among stocks or uniformly across time. So, spread your risk.
- Accept that markets work. If you hear on the news about the great prospects for a company or sector, chances are the market has already priced that in.
- Look to the future. Financial news is interesting, but it is about things that are in the past. Investment is about what happens next.
- Don’t fall in love with your investments. It’s easier to maintain discipline if you maintain a little emotional distance from your portfolio.
- Rebalance regularly. This is another way of staying disciplined without seeking to time the market.
These are simple rules. But they are all practical ways of taking your ego out of the investment process and avoiding the sunk cost fallacy.