In case it’s not yet apparent, we’ve been on a roll this summer covering behavioral biases that can wreak havoc on otherwise sound investment plans. Usually, our advice is to heed the words of Warren Buffett, who says, “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” Today, the lesson on sunken costs is closer to the theme in Kenny Roger’s song about knowing when to fold ’em. Sometimes, it’s time to move on from a losing investment hand, even if it means taking the loss.
What Are Sunken Costs?
Whether they represent a past mistake, bad luck, or a choice that made perfect sense at the time but no longer does, you are subject to sunken cost fallacy when a holding is no longer serving for your current, well-reasoned financial goals and desired risk levels … but, still, you hesitate to unload it. You may be vested in it emotionally, such as if it’s your employer’s company stock or it was bequeathed to you by your favorite uncle. Or you may feel something like this: “I’ve already spent so much time or money on this venture, I can’t stand taking a loss on it.”
There may well be reasons for approaching a trade with caution. Tax ramifications, sales loads or similar considerations may require careful planning before unwinding an undesirable investment. (Here’s where a professional financial advisor can come in handy.) But there’s a difference between planning for a transition versus being in denial about it.
A Sunken-Cost Illustration: More Moat Than Castle
Real estate represents a common source for sunken cost fallacies. Most of us remember firsthand the not-so-distant climate when it seemed that every real estate investment would appreciate for all eternity. You could buy a rental property, eagerly sink improvements into it with your own sweat equity or hired help, seek good tenants. And wait.
With the bursting of the housing bubble in 2008, many property owners are still waiting, still in the red. But they can’t quite bring themselves to sell. “It’s only a paper loss,” they tell themselves. “I’ll at least wait until I’ve broken even.”
If you are living happily in your home, by the way, you may indeed be best served by staying put no matter what the property would or would not fetch on the market. This is one of many reasons it’s best to consider your primary residence as the place you live your life – not as an investment per se. But if you’re throwing good money after bad on a real estate venture, and the remaining assets could be put to considerably better use within your globally diversified portfolio, what are you waiting for? Unlike fine wine, an undesirable investment rarely improves with age; it’s more likely to turn increasingly bitter.
Letting Go of Your Biases
We could readily write more posts about the importance of avoiding behavioral biases like sunken costs, herd mentality, confirmation bias and recency. We will no doubt return to these and related subjects in the future, because they’re just that important. In his review of William Bernstein’s new book, “Rational Expectations,” John Rekenthaler observes: “Emotions destroy investment performance. Somehow, some way, investors must suppress them.”
We agree, and are here to help. To continue your exploration, we recommend Bernstein’s “Rational Expectations” book as well as Jason Zweig’s classic, “Your Money & Your Brain.” While you don’t have to be a brain surgeon yourself (as is Bernstein) to be a good investor, it doesn’t hurt to heed the advice of this one.
For more information or to set up a consultation, contact Pathway Financial Planning at or email email@example.com.