Behavioural finance: Sunk cost
Moneylife Digital Team 10 March 2011

Why can’t we cut our losses?

Imagine you have paid Rs250 for a movie ticket… and half-way through the screening, you realise that the flick is not worth it—the plot is slow and the acting is terrible. Would you ditch the movie and spend your time on something better or sit through the pain for the rest of the screening? Most people would sit through—the money invested would act as a deterrent against walking out. In behavioural parlance, this is called the ‘sunk cost fallacy’.  

How does this manifest in investing? Once you have bought a stock and you find that it has lost its value, it becomes heart-breaking to sell it and book losses. Instead of swallowing a bitter pill, investors often stay invested to break even or buy more of the same to lower the average purchase price and get even. Terrance Odean, Michal Strahilevitz and Brad Barber conducted a study of 66,465 investors in the US between 1991 and 1996 and 665,533 investors between 1997 and 1999. The two samples were also different in terms of the size of the portfolios.

The authors calculated the proportion of securities held in the portfolio which were repurchased over a period of one year. The results showed that investors increased holdings of losing stocks more than that of the winning ones. For winning stocks, the probability of repurchase within 12 months was 9.4%, on average; for losing stocks, it was much higher (14.6% in the first sample and 12.8% in the second).

Markets are uncertain; valuations can fluctuate wildly for reasons beyond our control. Getting over the sunk cost bias and cutting losses promptly is crucial to investment performance. This is what we advocate, always.

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