Wednesday, 26 September 2012

Sunk Costs

Simon enjoyed the read of Ranjit Bolt's gambling problems, and had a comment which is worth repeating here:
Excellent piece of writing from Mr Bolt and well worth a read.
Personally I liked the quote: "Regaining a recent loss brings a special pleasure of its own, as any gambler will tell you: a weird, warped sense of redemption."

For a long time I felt losses much harder than I did wins. Losing a fiver was much more profound than winning a ton. Perhaps like with repeated usage of any drug over time, I've become numb to the highs and lows of individual wins and losses. This could probably be seen as both a good and a bad thing. I do however still get the odd buzz from pulling a losing position back to break-even or, even better, a profit. There is possibly no feeling quite as satisfying.

The idea of blowing 250K over any period of time though makes me a feel a little sick, but I guess it is all relative. I don't have a 5K overdraft and I don't have massive royalties from my literary works (yet).
It's certainly true that the pain of a loss is not outweighed by the joy of a win of the same amount. Losses hurt, and several studies have found this, but to be successful as a trader, or perhaps I should say to be the best trader you can be, you need to overcome this, at least to some extent. Simon says that over time, he has become numb to the highs and lows of individual wins and losses, and this is certainly true for me. After a while, wins become nothing more than green numbers on a spreadsheet, while losses are the red ones! Recovering from a loss to break-even feels better than a win of the same amount, because the loss that would have been painful, has been avoided.

Many traders find it difficult to 'red-up' even if it is the logical play, although most are happy to 'green-up' even if it is illogical to do so. 

Sunk costs are "retrospective costs that have already been incurred and cannot be recovered", but they influence our behaviour in trading, as in other areas of life. In English: "There is no use crying over spilled milk".
Robert Frank in his book Microeconomics and Behavior describes the case of two tennis courts at Cornell University, one indoor and the other outdoor. The indoor court has fees of $15 per hour and the outdoor court has no charge. Suppose you have already paid to play on the indoor court. You arrive to play on a warm, sunny afternoon and find that the outdoor court is free. Frank asks, "Where should you play, indoors or out?"
Frank reports that in surprisingly many cases people balk at playing on the outdoor court saying that they have already paid to play indoors. Even when he points out that the $15 fee is payable no matter which court they play on, it is a sunk cost, many still feel uncomfortable about ‘wasting’ the indoor court.

But something has to be wasted; either the $15 or the opportunity to play outdoors in the sunshine. In the end, both courts cost the same since $15 will be paid no matter which court is used. So if it is more pleasant to play outside in the sunshine, that is the rational choice.

Something similar can occur when we buy a stock that drops in price. Many people hesitate to sell such a stock even though they believe that they could get a better return with a different company. They hang on to the stock rather than ‘waste’ the money that is the difference between their purchase price and the current price. But, just as in the case of the fee for the tennis court, that money is a sunk cost. All that counts is what the stocks are worth now and how to get the best return on this money. (With stocks it is a little bit more complicated due to taxes and transaction costs.)
Another factor that can influence stock purchases is the effect of irrelevant information. In an experiment, groups of people were asked to choose between two apartments: the first is near the city but has a high rental, the second is further away but has a low rental. The experiment is set up in such a way that the split between the choices is roughly 50-50.
Then a third apartment is added to the list that is both further away than the second apartment and more expensive. Clearly this apartment is less attractive than the second one so you might expect that the outcome remains at 50-50 between the first and second apartments with none choosing the third. This is not the case. It turns out that the majority of people choose the second apartment.
The explanation is that people veer towards situations where there is a clear choice and away from more difficult choices. So they focus on the choice between apartments two and three and away from the choice between one and two.

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