Imagine two scenarios.
Scenario 1: You are looking to watch that latest Hollywood action flick you’ve been waiting for the past six weeks. Going by the pre-release popularity of the movie, you’ve had to pay Rs 500 per ticket, which is almost 3 times the normal price.
However, you are excited for the movie so the cost doesn’t pinch you that much. Now, just a day before your show, a couple of your friends who’ve already watched the movie tell you that it’s not worth watching at all. The hero’s acting is poor, and the story is very predictable and boring.
What do you do? You’ve already spent Rs 1,000 for a couple of tickets for you and your wife.
Scenario 2: You are looking to watch the same movie and have been lucky to get complimentary passes from your club. But just a day before your booking, you hear bad reviews about the movie and that it’s not worth spending three hours on.
What do you do? You’ve got the complimentary passes, which only a few people have received.
If you are a normal-thinking person, you’ll still go and watch the movie in the first scenario, when you paid for it from your own pocket.
However, in the second scenario, you would want to skip the show as it was anyways ‘free’.
Behavioral scientists call such behavior as…
The ‘sunk cost fallacy’
The ‘sunk cost fallacy’ states that we are unable to ignore the ‘sunk costs’ of a decision, even when those costs are unlikely to be recovered.
So if we’ve spent money on something that we later realise wasn’t worth it, we continue to hold it close to our hearts.
Let’s look at another example, this time from an investor’s perspective.
You’ve bought a stock at Rs 100 after doing a lot of research on it. You’ve studied the company, its products, competitors, and its management. In all, you’ve spent a lot of time in identifying the stock before buying it.
Going by your highly positive view on the stock, you’ve invested Rs 5 lac in it.
However, in one month after you bought the stock, it falls to Rs 80 and your total investment value comes down to Rs 4 lac. You know it is a temporary fall, as the company continues to do well.
The stock falls further to Rs 60. Your investment value is now just Rs 3 lac, down 40%. You start to panic. But you still hold the stock tight. After all, you know you did your research well and thus continue to maintain your faith in the stock.
In the meanwhile, there’s news of the company looking to exit some of its profitable businesses and the stock falls further to Rs 50.
You start to hate it. But you still don’t want to sell. You don’t want to get rid of it. Even if you realise later that buying the stock was a mistake as the company’s management was known for making bad decisions.
Your reaction is…
“It’s now too late! I’m already down 50%. Now I don’t want to convert the paper loss into real loss by selling the stock. And then, I spent so much time and energy finding this stock. Let me wait for some more time for it to come back to my cost price and then I’ll surely sell.”
So you end up with a situation where just because you have put a lot of time and energy into the selection of the stock, even when you realise that you must sell it, you are afraid to cut it loose.
It’s the ‘sunk cost fallacy’ at work here. Most investors fall into this trap and lose a lot of money by just staying invested in bad stocks, or good stocks that turn bad.
Now imagine if you hadn’t bought this falling stock but had received it as a gift from your father. In that case, perhaps you wouldn’t have hung on to it quite so long.
Just get over that sinking feeling
Learn to walk away from bad decisions you made in the past.
You see, we all make financial mistakes. But when you realize you’ve done something wrong, try not to think about the money (and time and emotion) you’ve already spent. Instead, decide what to do based on the present and the future.
So, don’t think how much you lost given your investment value fell from Rs 5 lac to Rs 2.5 lac. Think what you can do with Rs 2.5 lac now so that it grows back to Rs 5 lac. And staying with a stock that’s not going to take you there isn’t the right choice for you.
In Why Smart People Make Big Money Mistakes and How to Correct Them, the authors write:
“Once your money is spent, it’s gone. It has no relevance. To the extent you can incorporate that notion into your financial decisions, you’ll be that much better off for trying. If you’re debating the sale of an investment (or a home), for example, remember that your goal is to maximize your wealth and your enjoyment. The goal is not to justify your decision to buy the investment at whatever price you originally paid for it. Who cares?
What counts, in terms of getting where you want to be tomorrow, is what that investment is worth today.”
So, just get over that ‘I can’t quit’ trap.
Your sunk cost is already sunk in the past. Now, don’t sink your future worrying about it.
Instead take a leaf from the mistake, and get on the path to becoming a smarter investor.
Dear Vishal,
I have gone through and still going through The ‘sunk cost fallacy’ in many of my stocks. While I do agree with your view ‘don’t think how much you lost given your investment value fell from Rs 5 lac to Rs 2.5 lac. Think what you can do with Rs 2.5 lac now so that it grows back to Rs 5 lac. And staying with a stock that’s not going to take you there isn’t the right choice for you. ‘ The problem lies in identifying a stock that will make your 2.5 back to 5Lac + the lost time. In some stocks 3 has become 1, so to find a stock(s) to make 1 become 3 + the lost time is equally a tough one. It is equally true that no point sitting in losses on the same stock that made 3 to 1 with a hope that one day you will recover the losses.
Ajay, it’s indeed a tough task to find a stock that can help you regain the wealth you lose by investing in bad stocks. But that’s just a way to suggest, as you rightly pointed out, that there’s no point hanging on to the losses in bad stocks.
There has to be some “cost” that we incur by making stock picking mistakes, and that cost is in the form of “time” we take to regain our losses…and that can only happen when we cut short our losses and reinvest the left-over capital in good stocks.
You could consider a NIFTY ETF as part of your portfolio. It will provide FD plus type of returns assuming you enter at reasonable levels and do so like a SIP.
I find a contradiction here. Isn’t it one of the principles of value investing that one should not pay much attention to the price. And you go on to say that if a stock has sunk below your comfort level, sell. Does it mean we are looking at short term price movements to decide if the stock pick was correct ?
And one will naturally tend to look for bad management behaviour after a stock plummets and therefore be more likely to find it. The investor might have come across the same information earlier, but now that the price has dropped, he pays more attention to it.
Please help.
Thanks Sarthak! What I’m trying to say here is that in investing, your cost price does not matter when you are looking to make a decision today. What matters today is the stock’s price and its intrinsic value. You need to decide based on these two numbers whether you want to sell or hold the stock or buy more of it, not based on the price you originally purchased it at.
That’s why, averaging a falling stock just for lowering your average purchase cost is often a bad idea, because you are anchored to your original cost (that was higher) and not focused on what the intrinsic value now is.
That’s why, you must not sell a stock just because it has fallen, but because your original assumptions don’t stand true – maybe the business has worsened, or maybe the management’s integrity has become questionable.
So, effectively, what I’m trying to say here is that your cost is sunk…don’t make your present decisions based on that.
Hope this helps. Regards.
Also could you please review this tool ” https://www.screener.in/ “.
Would it be possible to link the data exported to excel through this tool to the excel sheet that you gave us to evaluate the intrinsic value of a stock.
Thanks
Does this not contradict Buffett’s saying “Be greedy when others are fearful”?
Such steep price corrections are usually due to some questions raised on the company and very rarely due to external/global factors (like 2008)
Ahhhh, this happens often. But then you revisit your assumptions and if they hold true stick with it or even average out else I agree just jump, the hole can get deeper !
Sir firstly very well explained. Very apt examples used:)
I remember asking you this question during the workshop. This post has brought total clarity for me in the concept of sunk cost.
Just asking, personally how do you react to your stock price falling? 🙂
This is what is happening with EIL these days
Nice article Vishal. However, practically it’s very difficult to follow. Stocks like Bhel, Tata Steel, Voltas, Engineers India and so many value scrips are declining since ages. Their intrinsic value also keep declining. There is no margin of safety even in long term. The so called fairly valued stocks are going up and up.
Almost a year back, i bought expensive United Spirits and undervalued Voltas as per valuation metrics. Today, United Spirits is 250% Up with bright future ahead even with expensive valuation whereas Voltas is down 30% from my buying price with pathetic balance sheet. Problem with market since 2009 is only expensive stocks are giving good return and cheap stocks are giving negative return. There is also two more major problem are opportunity cost and time loss. If one has bad stock with corporate governance issue and too much debt, one should definitely exit but what if stock is fine with few bad years of earnings ? One should Hold for decade for decent return (may be) or exit and buy so called fairly / expensive stocks that is growing 20%-30% CAGR consistently and can give good return in few years only (most likely). This is the question i always ask but with no proper answer 😉 May be that’s why i am making great return in expensive stocks and losing some of my profits in value picks for last few years.
Exact same feeling I am having about BHEL. I started putting my money at value Rs. 210. Now the prices are even below Vishal’s intrinsic value. 🙂 Not sure what I will do with this stock. 🙂
Sir, your articles are truly motivational and inspiring. I open your web page every evening at around 8 in office and enjoys 3,4 articles before I call it a day. Also, I have seen lot of similarities between the books you recommend and your writings. When I ordered Art of thinking clearly after looking it here, i was amazed seeing how many things I have already read. Sometime back, I used to read blog of Subramoney regularly but now that is replaced by you.
Not only I enjoyed articles but also add value to myself.