Let’s say you had two tickets to the Super bowl which was to be held in a neighboring city hundred miles away. These tickets were given to you on a complimentary basis. Imagine if on the day of the game, the river between the two cities has flooded and it would be dangerous to go and watch the match. What would you do?
Let’s also consider you purchased two tickets to the Super bowl which was to be held in a neighboring city a couple of hundred miles away. You paid $500 each for this special event. On the day of the game, the river between the two cities has flooded and it would be dangerous to now go watch the match. Then what would you do?
Behavioral finance experts suggest that in the first case, people would not go to watch the match, while in the second case they will more likely do. In reality, this is irrational. This is because the money for the tickets has already been spent no matter who spent it. The decision, now regarding the additional risk to be taken, must be independent of what has happened before. However, in reality this is not the case. This is what traders often refer to when they say “Throwing good money after bad”.
What really happening is that the investor has created a psychological tie with the investment. Therefore, he has two choices. Firstly, he can admit that the past decision was a bad decision and abandon the investment but this would entail severe costs in terms of ego. Secondly, he can continue justifying the investment because of the past. This will only make matters worse. This is the reason why this pattern of behavior is called the “Sunk Cost Fallacy”.