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The Sunk-Cost Fallacy and Investing

Wikipedia defines ’sunk costs’ as past costs that have already been incurred and cannot be recovered. Prospective costs are future costs that may be incurred or changed if action is taken. Traditional economic theory tells us that only future costs are relevant to rational decision-making. Real world evidence from behavioral economics indicates that this theory does not hold up.

Say you have tickets to a great basketball game and you paid several hundred dollars for these tickets. To attend this game you will need to drive one hour. On the big evening there is a snowstorm and now you need to make a decision. (Let’s assume the weather is not so bad that there is a state of emergency; the game is still on.) Do you make the drive? Or, do you stay home and watch the game from the comfort of your family room?

Now, let’s say someone gave you the tickets. Does that change your decision? What if you had not yet purchased the tickets but were planning to head down at the last minute and buy tickets once you arrived- do you still make the trek? Behavioral economics says that people are far more likey to make the drive if they already paid for the tickets. If they have not paid for the tickets, most people would curl up on the couch and enjoy the game from home.

Now, let’s say you purchased Cisco stock back in March of 2000 for $135 per share. One year later the same stock was worth $24/share. (Today the stock is trading around $22.) Many would not have sold one year later feeling the ‘loss’ so acutely that they could not stand to make that loss permanent. Instead, many of us think of ‘waiting’ for it to come back so we can recoup our losses. Of course, in situations like this it is far better to sell the stock and realize the tax loss which is something that can actually be of value to us. Unfortunately, once we have made the investment it is very difficult to recognize the loss.

While it may seem difficult, once we have paid for something and cannot recoup that loss, it is better for us to think ahead to the prospective costs involved with any investment. Just having this knowledge may help us to make better investment decisions in the future.

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