Losing Money? What Now?

Underwater Trades

Sunken costs
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The following quote comes from: Misbehaving: The Making of Behavioral Economics by Richard Thaler:

If you find yourself thinking along these lines [placing a wager that recovers lost money and gets you back to break-even status is so important, that taking extra risk is acceptable], then don’t worry, you are like the majority of people in the world today.

Just remember that though it can be very tempting to take a big risk in order to break even, that risk might put you much further in the hole. Before you take that gamble, think very seriously about the consequences of losing.

If you can consider it rationally, you will realize that it’s much better to stop before you do further damage. Sometimes it’s better to accept a loss and walk away—much like sunk money.

It is very difficult for most people to walk away from a situation in which money has been lost. The temptation to continue playing the game is so strong -- not only for financial reasons -- but because it is psychologically unsatisfying to end the game as a loser. Getting back to break even is almost addictive.

In different language: Consider this scenario: You play poker, bet at the racetrack or invest in the stock market, and find yourself losing $100. You can walk away or continue to play. For most people, the possibility of recovering that $100 is so tempting that they may wind up losing far more money than they can afford to lose -- just in an attempt to recover losses.

This is the important part that is difficult for rational people to recognize: When people make an investment, earning $100 has a certain amount of pleasure associated with it. However, if they first lose $100, then earning $100 is far more satisfying -- despite the fact that it has the same financial value.

"Not losing" is more satisfying than "winning" -- and that may lead to taking more risk than is prudent.

Sunk Cost

When money has been lost and cannot be recovered, there is nothing that can be done. That is the sunk cost.

Rational decision making is based on the same set of rules that are used when initiating any investment: Is this the appropriate time to invest money in this stock or option position (i.e., hold the position), or accept the fact that the trade has not worked as expected and that current market conditions are not encouraging (i.e., sell the position).

That decision is never based on the fact that there is sunken money in the trade.

When neither investing nor gambling is involved, people are much more rational when faced with a sunk cost situation. For example: You have theater tickets for tonight but are suddenly taken ill with a bad flu. Amid the pain and discomfort, going to the theater is not a consideration. Sure you may try to give away, or sell, the tickets, but you accept the fact that the money is lost and you forget about it. 

Why do investors fail to understand this simple situation? One of the most important considerations associated with each investment is risk. Just how much money is at stake? Can we afford to lose that much money? Is our position size too large? What are the chances of losing money on this trade? Note that all these considerations involve risk management -- something that seems to disappear when making risk-based decisions concerning a losing trade.

It makes no sense to take on too much risk in an attempt to recover a loss when you would never accept such risk when making a brand new trade.