The ABCs of Behavioral Biases: Part VI

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.

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 challenging to let go, even if you would be better off without it.

When is it helpful? When a person, project, or possession is indeed worth it to you, sunk costs – the blood, sweat, tears, 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 can prevent you from unloading an existing holding once it no longer belongs in your portfolio. For better or worse, you cannot go back in time and alter what you’ve already done with your investments. But you can (and should) keep your portfolio optimized for capturing future expected returns according to your own goals and the best evidence available to us today.

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 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 repeatedly been losing to your peers. This may prompt you may 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 profoundly damaging to your long-range plans if you compare your 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. Stop chasing past returns you wish you had received based on random outperformance others (whose goals differ from yours) may have enjoyed. You’re better off tending to your 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!