Behavioral Investing and Finance

The sunk cost effect considers past non-recoverable costs, time, or resources in deciding the future. In other words, whatever effort, money, or time you have put into an investment does not matter when looking at the investment in the present and predicting the future. The sunk cost effect varies by the cost or effort put in and the time of when that cost and effort was completed.

Here is an example of the sunk cost effect you might have experienced. Supposed you purchased $100 concert tickets for next Saturday to see your favorite band. But there is a big snowstorm coming on Saturday and getting to the concert would be a significant hassle and take 2 times a long to get there and get back. Because you paid $100 in “sunk costs,” you will likely go and don’t consider the current hassle of attending. You don’t want to feel the emotional pain of a loss from the purchase of these tickets.

Now, if you waited for 3 hours to get this ticket, then you will be even more likely to go because you put in extra effort in the sunk cost. If you purchased this ticket in the last 24 hours, you would also be more likely to go than if you purchased the ticket 6 months ago, as the immediacy creates more of a sunk cost effect. Older sunk costs do not hurt as much emotionally.

On the flip side, if the tickets were given to you for free, you would more likely not go, as you don’t have any sunk cost invested in the tickets, and the hassle would be too much.

Sunk Cost Effect on Personal Finance

Here is how the sunk cost effect may work on you in your investments. Supposed you spent 4 hours of research on blockchain companies and found that Coinbase (COIN) is the company you wanted to invest in. So on October 18, 2021, you buy 100 shares at $293.34/share for an outlay of $29,334. The stock keeps going up, and you are happy with your research and choice.

However, in Nov 2021, the stock starts dropping, but you are still making a profit, so you stay the course but continue to follow the stock daily. In Apr 2022, it starts to take a bigger downturn, and you are losing money, but because you have invested so much money in the stock AND all the time researching, re-researching, and following the stock, your sunk costs are very high in terms of time, effort and money.

In May 2022, it hits around $61 per share; you have lost $23,234 on paper and only have $6100 left of your investment. Do you cut this bleeding off now and buy invest in something else? Most people would still stay the course and try to regain their money back because of the sunk cost effect, the break-even effect, and to avoid any emotional pain from the loss. If you sell now, you have physically confirmed your loss and experienced that emotional pain.

Rationally, you should research what is happening to COIN now and see what other investments may be better. You should baseline your money at $6100 and see how you can grow it NOW, not focus on your sunk costs or the past time and effort you put into COIN.

Getting over the sunk cost effect and emotional pain of a loss is difficult emotionally. One method to avoid this effect is to set upfront goals and expectations. When you purchased COIN, you could have set a sell limit order for, say, $350/share for a 19% gain but also set a stop loss limit order at $263/share to limit your losses to 10%. Setting goals upfront prevents the emotions of the moment to affect you. Might you miss out on some continued run-ups or bounces, sure, but this is a way to limit the pain from a loss and get a nice gain.