Good Money after Bad - The Sunk Cost Falacy

Andrew Feinberg has an interesting article on Kiplinger, Boiled Shrimp and the Sunk-Cost Fallacy, dealing with our tendency to throw good money at an investment that has gone bad.

I know dozens of friends, clients and acquaintances who under perform the market largely because they can’t part with their losers. If they buy a stock at $50 and it falls to $30, the last thing that they think about is selling. They focus on their sunk cost of $20 per share and all they want to do is get even. The fact that the stock may have plunged from $50 to $30 for a very good reason doesn’t interest them. They can’t sell because they have a large sunk cost and because they believe that, by not selling, they are somehow avoiding the loss.

Now, when this $50 stock reaches $5, they really, really can’t sell. Now it’s even more painful than before. The sunk costs are greater. The wounds to the ego are greater. And besides, math illusion enters the picture. Almost everyone thinks it is easier for a $5 stock to double than it is for a $25 stock to do the same. (That’s actually not true — low-priced stocks under perform every other kind of stock — but people intuitively believe it anyway.)

But what is an investor to do? Cut your losses and run!!

But the reason economists call it the sunk-cost fallacy is because your future attempt to enhance the value of your portfolio should be independent of what has occurred in the past. It is perfectly irrelevant that JDS Uniphase (JDSU) once traded for $150. The only interesting question is whether the stock is a buy or sell here at $3.59 per share. (Focusing on the $150 price is called anchoring, and it is yet another bane of investors.)

He gives a real good real world example:

You buy two nonrefundable movie tickets in advance. In between your purchase and the time of the show, you discuss the movie with 12 people you know well. Each tells you that you will loathe the movie, that it is the cinematic equivalent of Chinese water torture. Would you go see it anyway because you’ve already spent $24? A behavioral finance expert would say you shouldn’t. Why compound your financial loss by spending two or more hours of your life being unhappy? Why not do something more enjoyable instead? Why throw good money — in this case your enjoyment of life, which is what money sometimes helps you buy — after bad?

Reminds me of the story of the guy who tossed a $20 bill down the outhouse hole — when asked why he said he had dropped a dollar but had to make it worth going after.