Have you ever eaten food that tastes bad, but you continue to finish it because you have already paid for it?
Or have you ever tried to win a toy at a fair, and in the end, you spend so much more that it would have been cheaper if you just bought it yourself?
Or worse still, have you ever been in a bad relationship, but you stayed at it because you have already invested so much of your time and effort into it.
These are all real life examples of sunk cost fallacy in action
What is Sunk Cost Fallacy?
Sunk cost fallacy describes situations where people make irrational decisions because they have already invested the time, money or effort in it and they can’t recover those resources that they’ve put in. So it makes ‘sense’ to just continue with it. Even though continuing with it actually doesn’t make any sense.
Sunk Cost Fallacy in Investing
I bought into Vanguard Energy ETF for $104 back in 2018 when the oil prices fell from the peak. In the beginning of this year, I was down 50% on this ETF. I sold it off in June for $53 after I realised that Covid-19 pandemic is here to stay. I made a loss of almost 50% on this investment.
I had thought of holding onto it to break even before selling. After all, I have already invested in this for 2 years and if I sell it now, I will lose 50% of my investment. If I don’t sell it, all I have is unrealised losses.
Sounds familiar? This happens a lot more than we realised.
How to avoid the Sunk Cost Fallacy in Investing?
In my previous example, it was really difficult to sell off my investment at an almost 50% loss.
Learning to let go of the invested resoources
I had to let go of what I have already lost. When making the decision, I asked myself these questions.
- What does the future look like for the current investment?
- Are there better alternatives that I can invest what is left of my investment other than holding on to the current one?
The decision to sell off wasn’t hard to make based on these 2 questions.
With the Covid-19 situation lingering on, I know it is going to take a while for oil prices to recover. And even before Covid-19, oil prices were under pressure as there was a lot of surplus compared to the demand.
And of course there are a lot of better alternatives out there, such as the booming tech stocks. Or even switching it to the bank stocks which I know will recover sooner than the energy ETF.
Losing 50% in the ETF meant that in order to break even, I needed the ETF to double in price which means it needs to gain 100% against the current price. Between this ETF, a Tech stock and the bank stocks, which one is more likely to double in price?
So with that, I made the decision to sell off at a 50% loss and bought a tech stock.
And as of today, my tech stock is up 33% and the energy etf is in the $40s range. I’m still making a loss, but the gap is narrowing.