DEFINITION of Sunk Cost Trap
Sunk cost trap refers to a tendency for people to irrationally follow through on an activity that is not meeting their expectations. This is because of the time and/or money they have already invested. The sunk cost trap explains why people finish movies they are not enjoying, finish meals that taste bad, keep clothes in their closet that they’ve never worn and hold on to investments that are underperforming. The sunk cost trap is also called the Concorde fallacy after the failed supersonic Concorde jet program that funding governments insisted on completing despite the jet’s poor outlook.
BREAKING DOWN Sunk Cost Trap
Investors fall into the sunk cost trap when they base their decisions on past behaviors and a desire to not lose the time or money they have already invested, instead of cutting their losses and making the decision that would give them the best outcome going forward. Many investors are reluctant to admit, even to themselves, that they have made a bad investment. Changing strategies is viewed, perhaps only subconsciously, as admitting failure. As a result, many investors tend to remain committed or even invest additional capital into a bad investment to make their initial decision seem worthwhile.
Example of the Sunk Cost Trap
Jennifer buys $1,000 worth of Company X’s stock in January. In December, its value has dropped to $100 even though the overall market and similar stocks have risen in value over the year. Instead of selling the stock and putting that $100 into a different stock that is likely to rise in value, she holds on to Company X’s stock, which in the coming months becomes worthless.
Avoiding the Sunk Cost Trap
The best way to avoid the sunk cost trap is to set investment goals. To do this, investors could set a performance target on their portfolio. For example, an investor might seek a 10% return from his or her portfolio over the next two years, or for the portfolio to beat the Standard and Poor's 500 index (S&P 500) by 2%. If the portfolio fails to achieve these goals, it should be reevaluated to see where improvements could be made to achieve better returns.
If investors are trading individual stocks, they should have a predetermined exit point before entering a trade. This helps to automatically cut losing positions and avoid the tendency to commit more time and capital to investments that aren't working. (To learn more, see: Figure Out Your Investment Goals.)