November 6, 2017
The ABCs of Behavioral Biases (S-Z)
We’re coming in for a landing on our alphabetic run-down of behavioral biases. Today, we’ll present the final line-up: sunk cost fallacy and tracking error regret. If you would like to get caught up in our series, please click here to view the last article!
Sunk Cost Fallacy
What is it? Sunk cost fallacy makes it harder for us to lose something when we also face losing the time, energy or money we’ve already put into it. In “Why Smart People Make Big Money Mistakes,” Gary Belsky and Thomas Gilovich describe: “[Sunk cost fallacy] is the primary reason most people would choose to risk traveling in a dangerous snowstorm if they had paid for a ticket to an important game or concert, while passing on the trip if they had been given the ticket for free.” You’re missing or attending the same event either way. But if a sunk cost is involved, it somehow makes it more difficult to let go, even if you would be better off without it.
When is it helpful? When a person, project or possession is truly worth it to you, sunk costs – the blood, sweat, tears and/or legal tender you’ve already poured into them – can help you take a deep breath and soldier on. Otherwise, let’s face it. There might be those days when you’d be tempted to help your kids pack their “run away from home” bags yourself.
When is it harmful? Falling for financial sunk cost fallacy is so common, there’s even a cliché for it: throwing good money after bad. There’s little harm done if the toss is a small one, such as attending a prepaid event you’d rather have skipped. But in investing, adopting a sunk cost mentality – “I can’t unload this until I’ve at least broken even” – can cost you untold real dollars by blinding you from selling at a loss when it is otherwise the right thing to do. The most rational investment strategy acknowledges we cannot control what already has happened to our investments; we can only position ourselves for future expected returns, according to the best evidence available to us at the time.
Tracking error Regret
What is it? If you’ve ever decided the grass is greener on the other side, you’ve experienced tracking error regret – that gnawing envy you feel when you compare yourself to external standards and you wish you were more like them.
When is it helpful? If you’re comparing yourself to a meaningful benchmark, tracking error-regret can be a positive force, spurring you to try harder. Say, for example, you’re a professional athlete and you’ve been repeatedly losing to your peers. You may be prompted to embrace a new fitness regimen, rethink your equipment, or otherwise strive to improve your game.
When is it harmful? If you’ve structured your investment portfolio to reflect your goals and risk tolerances, it’s important to remember that your near-term results may frequently march out of tune with “typical” returns … by design. It can be deeply damaging to your long-range plans if you compare your own performance to irrelevant, apples-to-oranges benchmarks such as the general market, the latest popular trends, or your neighbor’s seemingly greener financial grass. Stop playing the shoulda, woulda, coulda game, chasing past returns you wish you had received based on random outperformance others (whose financial goals differ from yours) may have enjoyed. You’re better off tending to your own fertile possibilities, guided by personalized planning, evidence-based investing, and accurate benchmark comparisons.
We’ve now reached the end of our alphabetic overview of the behavioral biases that most frequently lead investors astray. In a final installment, we’ll wrap with a concluding summary. Until then, no regrets!