The sunk cost fallacy is a common cognitive bias in trading and investing where traders make decisions based on the amount of money or time they've already invested in a trade, rather than on the current and future potential of that trade. This fallacy leads traders to hold onto losing positions, thinking that if they keep going, they can recover their past losses. In reality, the decision should be based on the potential of the current market condition, not on the past investments.

What is the Sunk Cost Fallacy?

The sunk cost fallacy refers to the irrational decision-making process in which individuals continue investing in a project or trade based on past investments (time, money, or effort) rather than on current or future value. In trading, this typically occurs when a trader holds onto a losing position, hoping to "break even" instead of cutting losses. The term "sunk cost" refers to costs that have already been incurred and cannot be recovered, making it irrelevant to future decisions.

Why Does the Sunk Cost Fallacy Occur in Trading?

The sunk cost fallacy occurs in trading due to a combination of psychological factors like loss aversion, emotional attachment, and the desire to avoid regret. Traders may hesitate to sell a losing position because they feel that doing so would "realize" the loss, which can be uncomfortable. There is also a tendency to believe that further investment might eventually turn the situation around, which clouds rational decision-making. This leads to holding onto bad trades longer than is wise, further increasing the losses.

Examples of the Sunk Cost Fallacy in Trading

Here are a few common examples of the sunk cost fallacy in trading:

• Example 1: A trader buys 100 shares of a stock at $50 each. The stock price falls to $30, but the trader refuses to sell, hoping that the price will recover to break even, even though the outlook for the stock remains weak.
• Example 2: A trader spends several hours analyzing a trade setup, but once the market opens, the conditions change, and the trade becomes less favorable. Instead of cutting losses early, the trader holds the position, hoping for a reversal.

How to Overcome the Sunk Cost Fallacy in Trading?

Overcoming the sunk cost fallacy requires a shift in mindset. Here are a few tips to help you avoid this bias:

• Focus on future potential: Make decisions based on future market conditions and not on past investments. If a trade no longer has favorable prospects, it's time to cut your losses.
• Set clear exit rules: Define your stop-loss levels or exit strategy before entering a trade. This will help you avoid emotional decision-making when a trade is losing value.
• Accept losses as part of trading: Every trader experiences losses. Instead of focusing on recovering them, accept that losses are part of the process and move on to better opportunities.
• Practice discipline: Stick to your trading plan and avoid making impulsive decisions based on past investments.

Why Is It Important to Avoid the Sunk Cost Fallacy?

Avoiding the sunk cost fallacy is critical to successful trading because it helps you make rational decisions based on current market conditions, rather than emotional attachments to past investments. By cutting losses early, you preserve capital and avoid further losses. This is a crucial part of risk management and helps you focus on new opportunities rather than dwelling on past mistakes.