“Maine toh Yes Bank Rs. 325 mein liya than kuch saal pehle. Ab purane management ke saath jo hua, woh ho gaya. Naya management toh bohot badhiya hai. Maine aur shares khareed liye Rs. 17 mein. Average toh kaafi gir gaya hai. Ab bas yeh stock Rs. 50 ke upar chale jaaye, mera poora loss recover ho jaayega”
This is an example of a cognitive bias known as sunk cost fallacy – a tendency to continue investing in something simply because you have already invested a significant amount of resources in it (time, energy, money), regardless of the future potential outcome. Investors tend to be extremely emotional about their investments and tend to become irrational.
Here are a few ways in which investors fall prey to sunk cost fallacy:
- Holding onto a declining stock: Every market goes through ups and downs but if someone holds onto a stock, which was purchased at a high price, despite its deteriorating financial health, then you know the investor is being irrational
- Averaging downwards: As illustrated in the example above, if an investor keeps purchasing more shares as the price keeps tumbling, in the hope they will recover their loss, then they’re victims of sunk cost fallacy. They are motivated by recovering that loss instead of actually gauging the company’s health
“One does not catch a falling knife without hurting their hand”
- Ignoring negative signals: An investor ignores all the negative news around a stock, in the hopes that it will turn around at some point. This could include negative publicity, number of lawsuits, poor earnings reports or even whistleblower complaints
- Excess diversification: Yes, excess diversification is a thing. Investors may lock their capital in underperforming stocks, due to sunk cost fallacy, and utilise their additional capital in new stocks, thus making their portfolio imbalanced and very large. This will often lead to sub-optimal returns in the future.
These examples highlight how the sunk cost fallacy can impact decision-making of investors. It is crucial for investors to recognize this bias and make objective assessments of the current market conditions, company fundamentals, and future prospects when determining whether to hold or sell investments.