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.)

RELATED TERMS
  1. Sunk Cost

    A cost that has already been incurred and thus cannot be recovered. ...
  2. Bag Holder

    An informal investment term used to describe an investor who ...
  3. Superiority Trap

    A psychological or behavioral trap that leads people to believe ...
  4. Bear Trap

    A false signal that the rising trend of a stock or index has ...
  5. Irrelevant Cost

    An irrelevant cost is a managerial accounting term that represents ...
  6. Value Trap

    A value trap is a stock that appears to be cheap because it has ...
Related Articles
  1. Insights

    How To Recognize Sunk Costs

    Find out about sunk costs and why "getting your money's worth" can cost you more than you think.
  2. Investing

    8 Psychological Traps Investors Should Avoid

    There are a number of very common psychological traps or errors that investors typically make. You can save a lot of money and misery by avoiding them.
  3. Investing

    Traps That Lead to Market Underperformance Part II

    There is a vicious investing cycle that impacts many young and first-time investors.
  4. Investing

    5 Methods To Avoid Value Traps

    Learn about five key factors that can help investors identify and avoid value traps in their stock market portfolio selections.
  5. Investing

    Traps Leading to Market Underperformance Part III

    Many investors rely on the wrong things when it comes to evaluating and then acting upon their investments. Here are three points to consider.
  6. Investing

    Value Traps: Bargain Hunters Beware!

    Find out how to avoid getting sucked in by a deceptively inexpensive stock.
  7. Investing

    Beware The Index Hugger

    These funds put the squeeze on your money. Don't pay for service you're not getting.
  8. Managing Wealth

    3 Websites With Private Jets for Sale

    If you're in the market to buy a private jet, here's how to narrow your search to find the right plane for you – and where to look.
  9. Financial Advisor

    Is China Suffering From the Middle-Income Trap?

    After having sustained a rapid economic boom for decades, China now has slower-than-expected growth. Is it falling into the "middle-income trap"?
  10. Investing

    Using Logic To Examine Risk

    Know your odds before you put your money on the table.
RELATED FAQS
  1. How can you avoid the sunk cost trap?

    Read out how the sunk cost trap works, an example of how it affects decision-making and how to avoid it when making economic ... Read Answer >>
  2. Why should sunk costs be ignored in future decision making?

    Learn about sunk costs, why sunk costs should be ignored in the decision-making process and why future costs should be considered ... Read Answer >>
  3. What is the difference between capital investment decision and current asset decision?

    Learn how capital investment decisions are long-term funding decisions, while current asset decisions are short-term funding ... Read Answer >>
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center