In life and trading, we are only human. Making mistakes is natural for us, especially because our own mind lays traps here and there. With no opposition from our part, we obey and get caught. How can we resist the irresistible?
By being aware at least. Read on to uncover two popular unintentional fallacies – sunk cost and house money effects.
Sunk cost fallacy. How it works?
The sunk cost effect is the flawed logic that our previous investments – money, time or effort – matter in decision-making right here, right now.
Putting it simply, sunk cost is any incurred cost that can no longer be recovered. Even if the retrospective investment hasn’t paid off, the fallacy victim keeps ‘throwing good money after bad’ and lingers in the past instead of considering future benefits.
Crime against common sense continues as the poor victim keeps investing while his or her losses pile up. Be it a project, a private life issue or a trading decision, it can be hard to quit because you have committed. No wonder that another name for the sunk cost effect is escalation of commitment.
Our daily lives vividly illustrate this kind of reasoning error.
Here’s a situation: a diner is having a prepaid meal. Although there’s no room for desert, he or she keeps stuffing themselves. Why? Because they paid for the food already, i.e. he or she is bound with financial commitment.
Another example: Jill has been working for company X for 10 years. She feels she has exhausted herself working for the employer. She wants to try something different. ‘But how can I quit? I’ve dedicated so many efforts and so much time to working here.’ Jill will hold on to her job, although it is no longer rewarding, and it will be harder and harder for her to go in the future.
Sunk cost fallacy in trading
The sunk cost fallacy can drive your trading decisions as well.
Let’s say Bill invested £10,000 in shares of company XYZ. In a year, the holdings are worth only £1,000. Instead of selling the shares and investing into another company, which is a potential profit generator, Bill keeps holding on to the depreciating stock. The reasoning behind it is ‘I’ve come too far, I’ve invested too much and I’ve been waiting for too long to to stop now!’ Discarding the long position on company XYZ stock will mean, subconsciously though, that Bill admits his failure.
House money effect. How it works?
This is another effect that can derail traders from optimal decisions.
The fallacy originates in the casino, getting its name after the gambling phrase ‘playing with the house’s money.’
House money is a component of a mental accounting concept. First introduced by the economist Richard Thaler, mental accounting implies that individuals categorise personal funds differently and, thus, can spend and invest them irrationally.
Let’s get back to where it all started – a casino. Usually, gamblers have an initial budget and winnings, which are referred to as house money. Mentally, they keep these two groups of money separately and assign each group different amount of risk. House money gets a higher risk limit, meaning that people are more willing to take risks after they earn profit.
House money fallacy in trading
In trading, the house money effect works quite similarly.
People come into trading with an initial capital. If their trades are successful, they accumulate profits as well. Victims of the house money fallacy will treat gains as house money and keep it apart from the rest of the capital. Such traders are prone to take more risks after generating substantial profits.
Let’s take Adam. He has £1,000 of initial capital in his account. Adam is a risk averse trader, so knowing that stock A is not risky, he goes long on (buys) the instrument. However, a sudden rise in the asset prices brings Adam a £100 profit. Now, he has house money at his disposal. His reasoning is ‘after this winning trade I have a financial cushion to protect me. I’m going to try a riskier asset.’ The previous gains reduced the trader’s sensitivity to risk and he opens a position on stock B – a very volatile, hence, risky instrument.
Sunk cost vs. house money: fallacy against fallacy
The two effects are similar in that traders are willing to take considerable risks after a meaningful event: after a heavy loss (sunk cost fallacy) or a huge gain (house money fallacy).
You probably suffer from one of the fallacies if you:
choose to speculate on more volatile, hence riskier markets; or
make trades much more frequently; or
hold on to your assets for too long; or
set bigger size of your positions; or
increase your risk per trade percentage.
It goes without saying, neither of the two fallacies is better or worse. Both are irrational behaviour patterns that hinder us from reasonable decision-making. In trading, it’s more efficient to act rationally and rely on a trading plan and risk management.