Cut loss or stay put? How should we decide?

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In this article, we explore a dilemma that most investors face : cut loss or stay put. How should one decide when to cut loss and when to stay put? The answer perhaps lies in understanding a behavioural finance concept called "sunk cost fallacy" which tells us how and why we take decisions when faced with this choice.

What will you do in this situation?

Picture this situation : you came across a well crafted brochure that talked highly about a new online course on a subject that caught your fancy - it could be anything - from macro-economics to philosophy to palmistry to cooking. Something that aroused your interest in the subject and made you want to learn about that subject. The course demands 2 hours of your time every Saturday and Sunday for 6 weeks. It requires you to pay Rs.10,000 upfront. You go ahead, make the online payment and get started with the course.

By the 3rd session, you start feeling uncomfortable as you are really not getting anything significant out of the course. You decide to check out a few more sessions. By the 5th session (out of 12), you are becoming more edgy as you are really not getting much out of the course - at least, nowhere near what you expected when you signed up and paid the fees. You are trying to figure out what to do now. You have already finished 5 sessions out of 12, you have paid upfront anyway for the entire course - so you decide to go ahead and complete the course anyway. You hope that the next 7 sessions will be better than the first 5.

You effectively decide to commit 7 more weekend mornings to something you didn't enjoy in the first 5. Was it because you were convinced that the next 7 will be fantastic and will make up for the disappointment of the first 5? No, you did have a doubt, but you allowed hope to get the better of your doubt and decided to invest more of your valuable time and effort on something that wasn't really working well for you. Why did you take this decision? What emotion drove this decision? Would you have been better off "cutting loss", writing off the fees, forgetting it as a bad experiment, and making better use of the next 7 weekend mornings in doing something more pleasurable or productive? Well, if you still chose to give hope a chance and persevered with completing the course, you probably fell prey to what behavioural scientists call the "sunk cost fallacy". You decided to continue with a sub-optimal course because you have already paid for it and you have already invested 10 hours over 5 days in the course so far. The fact that you have sunk in this cost - in terms of money and your time - makes you hope that it won't go waste - and your decision to continue with the course is your way of hoping against hope that you can somehow recover good value out of what is already looking like a bad investment. Its not about the promise that the next 7 sessions hold out - its just an attempt to make the past effort and cost that you have already incurred (your sunk cost) not "go waste". In the process, you may well "waste" a lot more of your time.

Sunk cost fallacy is all around us

We are victims of "sunk cost fallacy" in so many little ways, in our everyday life. If you bought a Rs.300 movie ticket at a multiplex, discovered by the end of the first half of the movie that you are just not enjoying this movie, do you walk out at interval or hang on thinking that you've anyway seen half of it, may as well stay till the end. Besides, you have already paid for the ticket for the full movie anyway. Think of how you react when you order an expensive dish at a restaurant, which you didn't really like when you took the first bite. And think of how different your reaction would be if the dish you didn't like was an inexpensive one at a humble joint. Would you make an attempt to try and like the expensive dish in the second and third morsel, while wasting the inexpensive dish without further thought? If your reactions were different, what drove the different decisions? In all these cases, it is "sunk cost fallacy" that probably guided your decisions.

What is "sunk cost fallacy"?

Wikipedia defines sunk cost in this manner : "In economics and business decision-making, a sunk cost is a retrospective (past) cost that has already been incurred and cannot be recovered. Sunk costs should not affect the rational decision-maker's best choice." When you make the mistake of considering sunk costs in your future decisions, you are a victim of "sunk cost fallacy".

Your decision to continue with that online course or the movie you don't like should not be based on the cost that has already been sunk into it. You should decide whether that incremental time you are going to spend in the course or the movie, is in your opinion, the best possible use of your time going forward - something that either gives you pleasure or makes you productive. And if the answer is no, then ideally you should not commit more time towards that activity, regardless of how much time or money you have already committed to it in the past. What you have committed in the past is behind you. Don't let that influence what should lie ahead of you.

What causes us to commit this fallacy?

At the root of the sunk cost fallacy is a bias against admitting failure. If you are ready to admit that you made a bad decision about signing up for that course, you will find it a lot easier to "cut loss" and stop attending future sessions. It is when we have trouble with admitting failure, admitting a judgement error, that we land up potentially causing ourselves more harm, in an effort to prove or in a hope that the earlier decision was not wrong after all.

Sunk cost fallacy in the investments world

Sunk cost fallacy is an emotional stumbling block that one often encounters in the investments world. Lets say an investor has been holding on to an underperforming investment for the last 3 years. We know that his decision to hold on is probably caused by loss aversion (Click here to know more about loss aversion). Now, you come to him with an exciting investment opportunity, which you and the investor think can yield smart returns. The investor doesn't have any fresh liquidity, and will need to sell this underperforming investment to fund the new purchase. Chances are that he may think "I've waited for three years for this investment to give me healthy returns. Lets give it some more time - maybe the sector it is invested in will rally sharply, since it's got left out so far. Maybe I'll be able to make up for lost time if I just wait a little longer." The decision to remain invested in the underperforming investment is driven not out of conviction in the theme, but out of sunk costs - the fact that he has been waiting for 3 years for a return, makes him want to wait a little longer in the hope that the next rally will make up for those 3 sunk years of time.

We need to adopt a zero based approach, a forward looking approach

The reality is that all investors have finite resources and aim to make the best investments from these finite resources, in order to enable them to achieve their financial goals. Decisions on where to invest and where to remain invested should ideally be governed by what appear the most attractive opportunities, going forward. If we were truly rational as investors, we would ideally look at our portfolios at the beginning of each year, take a forward looking view of what looks like the most attractive investment opportunities, and then ensure that our portfolios are fully aligned with where we think the best avenues of the future lie. This would be a "zero-based" approach, which is purely rational and forward looking. The moment we bring in variables like what was our purchase price when we originally made our investments, how much time we have already been invested in individual funds and stocks, what has been the return to date on these investments vs how much we ideally wanted from them - and when we allow these variables to govern our portfolio decisions, we are no longer being rational and purely forward looking. We are falling prey in some measure to "sunk cost fallacy" which often produces sub-optimal results in the future as well.

An advisor's task - which is easier said than done - is to help investors understand that as investors, all of us have finite resources and the best way to deploy these finite resources is to look forward to determine the best investment avenues, rather than be guided by what was done in the past. Sunk costs should not influence a rational decision-maker's best choice of where he ideally wants his finite resources to be invested to help him realize his financial objectives.

All content in MasterMind is created by Wealth Forum and should not be construed as an opinion of Sundaram Mutual Fund.

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