Managing our emotions is hard especially when it comes to money and sometimes, the possibility of a big loss makes us behave irrationally. If you ever had an investment that was incurring heavy losses, I am sure you will understand what I am talking about.

Evidence of that irrationality is the sunk cost fallacy, which we will discuss now.

First thing first, what is sunk cost?

Sunk cost is basically an investment that can no longer be recovered by any means. This is the money that is gone for good and is never coming back.

Let me tell you a little story.

…of a Resource manager in an Indian IT firm

Say, you are a Manager in a big IT company and reporting to you are Jake and Amit. Jake is a good resource and you know he delivers the projects very well. Amit has just joined your team.

There is an onsite requirement in the US and you have to pick one of the two and you pick Amit.

Getting anyone onsite is no easy task in your organization. You spend a lot of time and effort getting Amit’s visa ready, arranging flight tickets, hotel accommodation and a lot of other formalities. On top of that, you personally spent time with Amit mentoring him and getting him set for his onsite assignment.

You endured all that and finally, you got Amit ready to go.

Amit flies to the US and you were relieved that you could manage all other work just in time.

Amit started working for the client as soon as he arrives. Here is where the real problem started.

In a few days, it became clear to your client that Amit is inexperienced and is not able to handle the workload.

The client is angry at you for sending an inexperienced resource and categorically says that he will not pay for whatever time Amit works because that’s below his expectations.

Anyway, you calm him down and ask for some time to figure out a solution.

Now, you’re in a tricky situation. At the back of your mind, you know that the client is right. Based on what you heard, Amit is not able to handle the workload.

But, on the other hand, you have already invested a lot of time and effort in getting Amit to the client’s site. Weeks of preparations that you put on getting Amit onsite: getting his visa, travel arrangements and not to mention that everyone knows that you selected Amit. If you have to bring him back, you would have to explain to all of them. The bottom line is that you are emotionally invested in Amit staying onsite.

What are you going to do now? There are two ways this situation can play out:

Scenario #1

You think, I have invested a lot of time and money in sending Amit to the client site. If I get him back, all that investment will go down the drain. Also, in the back of your mind, you personally feel invested with Amit. After all, you spent all that time mentoring him.

Instead of bringing him back, why not send him to a training institute like Oracle University? You spend another 1 lakh rupees and send Amit to a software training institute in the US for a short course and think he will be able to handle the workload after the training.

If it works out, people will forget all about the initial hiccups and life would be great.

You have very little conviction that it would work out but you do it anyway because bringing back Amit would mean accepting that you were wrong and putting that much effort again on someone else.

The reality is that he is an under-performer and cannot become a superstar overnight. That is what happened to Amit. He tried real hard but still could not cope up with the pressure and eventually he had to be called back home.

In this whole drama, you not only lost the initial money that you put on Amit but also additional money on training and the opportunity cost of having a billable resource onsite.

Scenario #2

You change the perspective towards the situation. Forget for a moment that Amit is there and forget that he was ever sent there. It is a sunk cost and you can not recover it.

Instead of looking backwards, let’s look forward.

Knowing what you know about the skill level of the two: who should ideally be at the client site? Amit or Jake? Of course, Jake.

But what about all that time and effort that you already spent on Amit? Wouldn’t that be wasted?  

They are already wasted- It’s already gone. It is sunk cost.

True, in the short run it will hurt. It is not easy to see your previous efforts go to waste and it is not easy to accept a mistake.

But between Jake and Amit, Jake clearly has a better chance of establishing good relations with the client and in the long run, he will generate more than enough to cover for the initial losses.

What you saw in Scenario #1 is called sunk cost fallacy. That initial time, effort and money are already gone. You have spent it. What really matters is the best course of action that will make you the most money from now onwards.

It is common in real life.

People spend over 10-15 years in a career that is not going anywhere ..but they still stick around because they don’t want the past 10-15 years of effort to go waste.

OR

Just because you are in a bad relationship for over 3 years, but you still keep working through it in the hope that things will turn around at some point.

How is the Sunk cost analysis applicable to the stock market?

People come to me, sir “I have bought Gitanjali Gems or some stock” at 100 and now it is down to 20? Should I buy more shares worth 2 lakh so that I can bring the average cost down?

I say forget that you ever invested in that company. Knowing what you know about the company right now, would you have invested in PNB today?

The answer is NO.

But sir, what about the losses in the first investment.

See, I understand your situation.

But what you have to realize is that every new rupee you put into the market is independent of the previous investments.

I recommend breaking the question down into two parts:

1. I have a bad investment in Gitanjali Gems and what should I do with it?
2. I have 2 lakh rupees. Where should I invest to get the maximum returns?

Now it becomes easier to answer.

For 1) my typical answer is to wait for rallies to get out and for 2) invest in some really top of the line companies like HDFC Bank or Kotak Bank.

Instead of accepting that we were wrong, we tend to be emotionally invested in them, add more money, time and resources to the original investment – all in the hope that it would work out somehow.

The reality is that it seldom works out.

Think about this. Not just in the stock market but also real life.

Don’t look backwards. Look forward.

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