One of the main differences between human and artificial intelligence lies in our emotions, which have a great impact on our behaviour. People build their own trading strategies by depending on many factors and characteristics, such as emotional intelligence, risk tolerance and perceptions. Unfortunately, despite behaving rationally in many aspects of their lives, people don’t always see how easily they fall into cognitive biases and logical fallacies.
Today we can distinguish (and what is more important – properly investigate) the most common cases, when people tend to take greater risks and in what circumstances. Traders, inclined to House Money and Sunk Cost effects may develop unreasonable trading patterns. Let’s see how it may happen.
What is “Sunk Cost” effect?
Sunk Cost is the ship that has already sailed. The spent money, lost opportunities, past costs, whatever. Just something that is lost permanently and irretrievably and should be considered irrelevant for future decision-making.
Other names for this fallacy are the “Investment trap”, the “Break-even effect” and the “Escalation bias”. It denotes the tendency to take higher risks after a series of losing trades. Sunk Cost Fallacy can be a trap for investors and traders, who continue pouring money into projects, only because of the significant amounts that have already been spent and will never return.
Sunk Cost Effect vs. Disposition and Loss Aversion biases
Sunk Cost trap is often described as “throwing good money after bad”, meaning that the resources and efforts have already been lost, no matter what you are going to do now.According to researchers Amos Tversky and Daniel Kahneman, the reason why people fall into the Sunk Cost fallacy lies in Loss Aversion. People are more inclined to avoid losses stronger than to try to acquire gains.
Besides, the experts denote that the inclination to the Sunk Cost fallacy may strengthen the Disposition Effect.
|Bias/Fallacy/Effect||Sunk Cost||Disposition||Loss Aversion|
|What is it?||Emotional struggle to decide whether to proceed and take greater risks after some losing trades, when time and money have already been irretrievably lost.||The effect, denoting that investors prefer to sell winning assets for nominal gains and keep losing assets to cut off nominal losses.||A tendency to avoid losses rather than try to acquire equivalent gains. To put it simply, it's better not to lose $10 than to find another $10.|
|Why does it happen?||People are often risk-averse over gains, but risk-seeking over losses.|
They express more sensitivity over losses than gains.
What is “House Money” effect?
The effect of the “House Money” took its name after the casino phrase “playing with the house’s money”, explaining the tendency for investors to take more and more risk if investing with profits.
It denotes that traders and investors are more willing to take higher risks and buy riskier stocks right after a profitable trade. It can lead to a chronic behavioural pattern, when investors intentionally take on risky trades, after a series of a profitable investment experience.
House Money effect vs Overconfidence and Hot hand biases
|Bias/Fallacy/Effect||House Money||Overconfidence||Hot Hand|
|What is it?||A cognitive bias that makes investors take greater risks with recently earned profits than they would take with their initial capital.||A dangerous tendency to believe you're a better trader than anyone else. It makes an investor trade too often due to an overoptimistic belief in the ability to gain profit by picking right stocks in the right time.||A flawed belief that a person who earned profit in a previous trade has a greater chance of further success in additional attempts.|
|Why does it happen?||Similar to 93 per cent of drivers, who believe they are Formula 1 pilots with better than average driving skills, investors often believe they can beat the market return.|
All the effects, described above, lead to taking greater risks and can overlap and significantly intensify each other.
However, financial decisions should be all about the future events. Our goal is to forget about the past, whether it was successful or not, and consider every project or trade as a separate event. There is nothing we can do in future to return the sunk costs. The best we can do is to ignore those costs and move forward with the unbiased decision making. Conversely, the line of successful investments that has already been completed has nothing to do with any particular trade you’re dealing with now. Remember that previous success doesn’t guarantee further profits to come.
Both the Sunk Cost and House Money effects describe the influence of past outcomes on future risky choices. The surveys, conveyed over the past two decades suggest people tend to act irrationally when investing and that can lead to disastrous results. If you want to avoid crucial failures, it's critical to understand the causes of these biases and detect these deviations in your own behaviour.
Pay special attention, if you systematically:
- Increase the size of your positions after a successful (unsuccessful) trade, or a series of successful (unsuccessful) trades
- Increase the frequency of trades after lunch following a profitable morning trading
- Trade more volatile instruments today after a profitable/loss-making day yesterday
If you realise that you tend to follow the same patterns, you may be prone to House Money (Sunk Cost) effects. The first thing you can do is to pay attention to your common feelings, stay rational and follow the risk-management rules.