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Have You Experienced the Sunk-Cost Fallacy?

Jan 4, 2016

In this issue:
» Is India Inc and investors ready to deal with 'unknown' risks
» Will rating agencies be more disciplined in future?
» Market roundup
» ...and more!
0:00
Richa Agarwal, Research analyst

Last weekend, I went for a movie with my friend. My friend booked the ticket online, and we went to the fancy multiplex. The movie was a disaster. I realized this after just 15 minutes of watching. I said to my friend, 'Let's walk out of theatre. I cannot bear this anymore. We will do something else.' My friend's adamant reply, 'Look, I have paid Rs 1,000 for this movie. I will not go. I will rather sleep than walking out.'

I knew my friend was experiencing a sunk-cost fallacy.

What is sunk cost?

In economics, a sunk cost is any cost that has already been incurred and cannot be recovered. It is the tendency of people to irrationally pursue an activity, even if it does not meet their expectations, just because of the time and money they have already spent on it.

This trap explains why people hold on to underperforming investments. Even corporates experience this as they tend to continue with nonviable projects because they have already invested money, time or effort that cannot be recovered.

Consider this recent example... A friend of mine is holding a long-term position in a stock. He was confident about this stock at the beginning. But as stock began to crash, he started averaging out - that is, buying at a lower price as the stock declines. He is now sitting on huge losses. The stock is down more than 60% from its highs. He has finally made up his mind to exit. But it's a little too late.

At Equitymaster, we always remind our subscribers to adhere to suggested asset allocation to equities, which should be decided upon after keeping aside some safe cash. This not only safeguards investments, but minimizes downside risk and irrational human behavior such as the sunk cost fallacy.

What is happening here?

The decision to invest additional resources in a losing position when better investments are available is a sunk-cost fallacy. This trap is also known as 'throwing good money after bad'. No matter what you do now, the resources and effort are already lost. Investors are not immune to this bias, and many have lost huge money because of it.

So why do sunk costs matter?

Assuming that increasing a position will 'make it work' only magnifies the commitment, and in turn can magnify the losses. That's not to mention the opportunity cost that one incurs, as the same efforts and funds could have been used in a better way.

According to researchers Daniel Kahneman and Amos Tversky, the reason people fall prey to the sunk-cost fallacy is loss aversion. People tend to have a much stronger preference for avoiding losses than for acquiring gains.

I guess... my friend was experiencing the same.

Avoiding the sunk-cost trap is simple: Consider only the future costs and returns, not the investment that's already been made.

Having a sunk-cost perspective is just one tool for rational investing. It is hardly the be-all and end-all to sound investing, but being aware of this bias can give you a bit more control.

What is your experience with the sunk-cost fallacy? How do you avoid letting past decisions influence your future actions? Let us know your comments or share your views in the Equitymaster Club.

Mark this Date in Your Calendar

The date is 23 January 2016.

This is when a few of us will have the rare opportunity to hear Bill Bonner and Ajit Dayal, together, in person! Going by my past experience, this is an opportunity no serious investor can afford to miss.

I am told only few seats remain for the Equitymaster Conference 2016.

So, unless you wish to miss out on this rare opportunity, do check out the details about the Conference and our speaker line-up here.

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3:00 Chart of the day

Year 2015, towards the end, must have left a bitter taste in the mouths of auto manufacturers. After a long period of slowdown, these companies were showing some signs of recovery. The festive season, supported by new launches in fact saw a double digit growth in the Utility Vehicle (UV) segment.

However, the trend came to an abrupt halt in December. The registration ban on diesel vehicles of 2000 cc and above in National Capital Region was not something that auto makers were prepared for (Subscription required). Caught unaware, these companies will need to rethink their business strategy. What happened was not a one time event, but a stark reminder of what all can go wrong and the need to be nimble and prepared enough to face such set backs.

The outcome can already be seen in the languishing sales volumes in UV category. It is not just NCR and diesel cars above 2000 cc that will reflect the impact. Such regulations will go a long way in influencing buyers' decisions for other categories and in other regions.

While it may take longer for companies to redesign their strategy, the message for investors is loud and clear - never take growth and profitability of large profitable companies for granted. And make sure that the management is competent enough to mold the business model to overcome such risks. My colleague Tanushree Banerjee has recently written an interesting piece on what such events tell you about stocks. To read more about the same, please click here.

Automakers Bear the Brunt of Regulatory Changes

4:15

It is quite unfortunate, but it takes a crisis for one to realise and acknowledge the flaws in a system. The recent proposal by SEBI to tighten noose over rating agencies and companies seeking ratings to make them more transparent indeed comes with a delay.

Few months back, a crisis in Amtek Auto had raised uncomfortable questions about the functioning of rating agencies. A sudden downgrade in the company's ratings eroded investors' wealth in a matter of days. And it was not an exceptional case. Investors in companies like Jai Prakash Associates, Bhushan Power and Steel etc, have burnt fingers for the same reason.

Yet, nothing was done to make these rating agencies more transparent and accountable. The danger of this oversight can be estimated from the fact that the world's worst biggest financial bubbles, and the crises that followed, were fuelled by rating agencies.

As per the recent proposal, disclosure norms should be tightened to address conflict of interest, independence and credibility issues with rating agencies. This will include companies as well which make selective disclosures depending upon how favourable the ratings are.

It is quite early to comment if this will bring a remarkable change . Nonetheless, the move by SEBI is in the right direction to check the threat of 'rating shopping'.

4:40

China halted trading in stocks, futures and options after a selloff that triggered circuit breakers. This is due to weak manufacturing surveys that revived concerns over the slowdown in the economy. This in turn had an effect on Indian equity markets. At the time of writing, the BSE Sensex was trading lower by 419 points and the NSE-Nifty was trading down by 132 points. Bears seem to be on a rampage as auto, bank, healthcare, FMCG and IT stocks drag benchmark indices.

4:50 Today's investing Mantra

"The four most dangerous words in investing are: 'this time it's different." - Sir John Templeton

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst).

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