Your Financial Investments and the "Sunk Cost Fallacy"

Managing my own investment portfolio I find myself grappling with Lose Aversion from time to time. This term, derived in economics from The Sunk Cost Fallacy, refers to the very human tendency to stick with a bad financial decision so as not to lose all the retrospective costs already invested in the venture. This then leads to what the theory refers to as prospective costs. In other words, sticking with a bad decision in order to save past investments only leads to the wasting of future ones.

Today's financial crisis began with liquidity shortfalls in U.S. banks. As bank stocks rapidly crashed a clear case of The Sunk Cost Fallacy took place. Some investors held on to their financial assets in the hope that they will rebound. Others increased their investments in an attempt to recoup even more of their loses when the market bounced back.

This same pattern of behavior was recorded in the 1929 stock market crash that ushered in the Great Depression. After a steady, unprecedented rise in stock values for six years, stock prices sunk sharply after September 3rd,1929. The fact that prices then regained over half their value is proof that many investors were falling into the trap of The Sunk Cost Fallacy. Prices eventually crashed on October 24th, 1929, in what became known as "Black Thursday", a day in which investors who lost everything jumped out of high-rise windows in sheer despair.

The Sunk Cost Fallacy only occurs when an investor gives in to emotions in place of rational judgment. No one likes to lose. I certainly don't like to feel like an idiot for investing money badly. There's nothing worse than that kick in the pit of your stomach when you log in to look at your investment portfolio and see that it took a hit overnight.

But I have learned that making a gut feeling decision just as I'm reeling from seeing a loss is a sure way to fall into the trap of the Sunk Cost Fallacy. Instead, I'll spend time reading the news on U.S. news websites and foreign ones. I'll read Fox News and CNN, Reuters and BBC. Since I read Hebrew, I'll read Israeli online newspapers, which delve deep in their news reporting.

When I read of political instability in Egypt I can assume that the Suez Canal might close, leading to trade implications worldwide. I also expect crude oil prices to rise. When I read of the increasing U.S. national debt and the growing pressure around the world to move away from the U.S. Dollar as the global currency, I expect to see inflation follow as the U.S. government increase monetary liquidity to sustain the debt. I also expect the U.S. to lose some of its stature in world affairs and, with it, the influence to support freedom-loving nations.

Because we live in a global economy, I know that everything is interconnected. When the U.S. currency weakens, I expect other countries with high national debt to experience the same problem. In real terms, this means an increase in prices and an erosion of lifestyle for the majority of people.

I then make investment decisions based on these facts. I expect gold and silver mining and metals to increase incrementally as the U.S. Dollar and Euro drop. I, therefore, assume that countries moving to the Gold Standard will become stronger for the simple reason that governments can reduce the value of paper money by printing more, but they can't print more gold (and gold mining is expensive and time-consuming).

These are hard truths to face, both in terms of world affairs and your own investments. But a refusal to see facts can only lead to The Sunk Cost Fallacy and with it greater and greater financial loses.

References

Wikipedia: Sunk Costs

Wikipedia: Financial Crisis 2007 to the Present

Wikipedia: Wall Street Crash of 1929

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