The sunk cost fallacy is a cognitive bias where individuals continue to invest in a decision or project based on the cumulative investment they have already made, despite new evidence suggesting that the decision or project is unlikely to be successful. This bias is problematic because it leads people to make decisions based on past investments rather than on the expected future outcomes.
The sunk cost fallacy is highly relevant to day traders in the stock market, impacting their decision-making and potentially leading to suboptimal outcomes. Here are several ways in which the sunk cost fallacy is related to day trading:
Refusal to Cut Losses:
Day traders who are influenced by the sunk cost fallacy may be hesitant to cut their losses on a trade. They might hold onto a losing position for longer than they should because they’ve already invested a significant amount of time, effort, and capital into the trade. The reluctance to accept a loss and move on can lead to further financial setbacks.
Doubling Down on Losing Trades:
Instead of cutting losses, some day traders succumb to the sunk cost fallacy by doubling down on losing trades. They may invest additional capital in a losing position, hoping to recoup their losses and make the initial investment “worthwhile.” This strategy can increase risk exposure and exacerbate losses.
Traders affected by the sunk cost fallacy may engage in chasing losses, where they take higher risks in subsequent trades to recover what they’ve lost. This behavior is driven by a desire to make up for past losses rather than making decisions based on the current market conditions.
Emotional Attachment to Investments:
The sunk cost fallacy can create emotional attachments to investments. Day traders may become emotionally invested in a particular stock or trade, making it difficult for them to objectively assess new information and adjust their strategies accordingly.
Ignoring Changing Market Conditions:
The sunk cost fallacy can blind traders to changing market conditions. Even when new information suggests that the original thesis behind a trade is no longer valid, traders influenced by sunk costs may be slow to adapt, sticking to their initial plan despite evidence to the contrary.
Ego and Pride:
Traders may resist cutting losses due to the impact on their ego and pride. Admitting that a trade was unsuccessful can be challenging, and some traders may hold onto losing positions to avoid acknowledging the mistake.