The Sunk Cost Fallacy

A study described in the book "It's Not An Option" by Jon and Pete Najarian asked respondents to consider the following two scenarios:

Scenario #1

You bought a $100 ticket to watch a football game. En route to the game, you lost the ticket. Would you buy another ticket?

Scenario #2

You decided to buy the ticket at the gate. At the gate, you realize you lost $100 cash. Do you still buy a ticket?

Most respondents said if they lost the ticket they previously bought (scenario #1), they would not buy another ticket because the game would cost $200. In contrast, if they lost $100 cash (scenario #2), they would still buy a ticket, and the game would still cost $100.

It may seem logical to most respondents, but this is the Sunk Cost Fallacy at work. A sunk cost is any expenditure made that is not coming back. You lost $100 in value in the form of a ticket or cash, and it is not coming back. The loss should not have anything to do with buying or not buying a ticket. The only question is whether it is worth paying $100 to watch the game.

Investors can be emotional and frequently commit this mistake: they invest but cannot accept the loss; they keep throwing good money after bad. It feels as if the money was not lost if it was "recovered" from the same stock. That is why losing a ticket and buying another makes it seem the ticket costs $200. They are two of the same things, so they should be added up, right? Actually, no -- these events are separate and distinct. The question every time should be whether or not it is worth investing based on what the investor knows about the investment at that time.

Investors should not have emotional attachments to investments and realize that lost money is lost and is not coming back. As an investor, you only get confronted with new investment opportunities and, at each discrete instance, must decide whether the investment is worth it based on what you know at that time.

Having emotional attachments to your investment is detrimental to your financial health. Do not fall into this trap and gamble out of a losing investment. As an investor, you should decide on each investment based solely on its merits.