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. Value Trap

    A value trap is a stock that appears to be cheap because it has ...
  2. Total Project Approach

    The total project approach is a method used to evaluates potential ...
  3. Regret Avoidance

    Regret avoidance is a theory used to explain the tendency of ...
  4. Jeffrey Sachs

    Jeffrey Sachs is an American economist and professor whose work ...
  5. Large-Value Stock

    A large-value stock is the stock of a large company where the ...
  6. Avoidable Cost

    An avoidable cost refers to variable costs that can be avoided, ...
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

    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.
  4. Investing

    Value Traps: Bargain Hunters Beware!

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

    Traps That Lead to Market Underperformance Part I

    There are many psychological traps that lead to defeat in investing. But I've noticed this one more than others over the past decade.
  6. Retirement

    Avoid the Downsides of Downsizing in Retirement

    Done right, downsizing can still be a good idea. You can have more money, simplify your life, and reduce home-maintenance and utility costs.
  7. Investing

    How To Avoid Emotional Investing

    Most investors buy high and sell low, but you can avoid this trap by using some simple strategies.
  8. Investing

    4 Signs Your Value Stock May Be Overvalued

    Value investing can make you money, but you have to look for traps. Overvalued stocks often correct, which means investors need to know when to get out.
  9. Investing

    Misconceptions About Past Performance And Future Returns

    Relying on an investment's past performance to guide your investment decisions is a losing strategy. Find out why.
  10. Investing

    Does Active Value Investing Pay Off?

    Learn about a well-researched paper that explores why active value investors underperform, and how value investing might be beneficial for your portfolio.
RELATED FAQS
  1. Are all fixed costs considered sunk costs?

    Find out why all sunk costs are considered fixed, but not all fixed costs are considered sunk; see why variable costs become ... Read Answer >>
  2. What are the types of costs in cost accounting?

    Cost accounting aids in decision-making by helping a company's management evaluate its costs. There are various types of ... Read Answer >>
Trading Center