- It is rational to make decisions based on their expected future return and not on the past
- Reality proves that most people are not rational
- Behavioral biases may be hard-wired in our brains and hark back to simpler times when decisions were about survival
- The lesson is to be forward-looking when evaluating investment decisions and remember that the past is irrelevant..
Every day, individuals make decisions -- some of them little and unimportant, others hugely important and life changing. Over the course of their lives, people make countless decisions about careers, education, relationships, investments, and places to live. Many of these decisions involve an investment of time, money and effort, and some of them inevitably turn out to be mistakes that need to be undone.
It would be rational to evaluate the outcomes of all past decisions exclusively on their expected future payoffs and costs and not on the past, which should be irrelevant. Reality proves however that most people are not rational.
When making a decision, they more often than not end up taking into account the costs they have already incurred. Research shows that a person is less likely to reverse a decision which has already cost them a high investment of personal resources. This decision-making bias is called the "sunk-cost fallacy," or, alternatively, "escalating commitment." This is a widespread phenomenon which affects all areas of decision making. Furthermore, research shows that a person committing a "sunk-cost fallacy" is prone to develop unrealistically optimistic expectations about the future benefits of the decision. In an effort to reach an unbiased outside perspective to evaluate past choices, individuals often seek the help of experts such as psychologists. Corporations achieve the same goal by hiring outside consultants.
Movies and fiction have long been fascinated by what would happen if people could switch bodies and live someone else's life (e.g., "Freaky Friday," "13 going on 30" and many others in this genre). While the idea of an individual taking over someone's past decisions is pure fantasy in personal life, it is an everyday occurrence in the business world, with new managers taking over firms and re-evaluating investment decisions made by their predecessors. New corporate managers are more likely to identify and scrap inherited underperforming projects and new bank executives are more likely to write off bad loans. It is therefore not surprising that investors believe that entrenched company founders destroy corporate value, and that stock prices go up upon the news of their deaths. It is quite common to see large write-offs for abandoned projects in a corporate income statement when a new CEO takes over, an occurrence termed "big bath" in accounting.
Since the research I have described so far dealt only with real investment decisions by banks and corporations, one could argue that the abandoned projects are unique and have many unknowns, and that the preceding manager who initiated the projects could have had positive private information that the new manager lacks. But what about stock investments? I analyzed the impact of changing the managers of active mutual fund portfolios (that is, the fund managers who select stocks for their portfolios rather than passively investing in a stock index) in a 2011 paper and found that even if the old managers were highly skilled, among the first things that new managers do is to identify and sell underperforming stocks. In this setting, one can easily compare the behavior of new managers who took over existing stock portfolios to that of continuing managers who created their own stock portfolios. The data confirm that the proclivity of new managers to sell off losing stocks is much stronger than that of the continuing fund managers who originally bought the stocks. In other words, a manager who did not personally buy a stock that subsequently lost value is much more likely to sell it. Does this behavior help increase subsequent fund returns? The answer is yes. As demonstrated in a 1993 research paper, stocks that have underperformed for the past 6 to 12 months on average continue to underperform for up to a year in the future. Likewise, the outperforming stocks will continue to do well in the future. This effect is called the "momentum effect." In light of this statistical regularity, it is rational to sell losers and re-allocate the funds to other stocks with better future prospects.
If professional money managers are subject to the "sunk-cost fallacy," individuals who personally trade stocks through trading platforms such as Charles Schwab, TD Ameritrade, Fidelity, are even more prone to make investment mistakes because they are far less experienced. Using anonymous data on retail investor trades from Charles Schwab -- research has shown that individual investors are subject to what has been identified as the "disposition effect." That is, the predisposition to hold on to loser stocks for too long and to sell winner stocks too soon.
Losers and winners are defined for each investor separately based on the difference between the current price and the purchase price -- losers are stocks that have declined in price, and winners are stocks that have increased in price. Before deciding whether to sell a stock or continue to hold it, a rational investor, would not factor in the price paid to buy the stock. Data show us however that the price paid to buy the stock turns out to be a very important input into the trading decision of a typical retail investor. It is one of the reasons why retail investors typically perform poorly when compared to those who just buy and hold an index fund. Selling winners too soon destroys value because statistically, winning stocks usually continue to do well in the future, and the seller ends up missing the high future return. Holding on to losers too long is likewise value-destroying because, the funds could be re-deployed to buy stocks with higher expected returns. The "disposition effect" exists across cultures and countries. Since the publication of the original paper, which was based on U.S. data, the effect has also been documented among retail traders in China, Finland, Israel, and Portugal.
The "sunk-cost fallacy" is not limited to stock traders. Plenty of households do not invest in individual stocks, but their "sunk-cost fallacy" is observable through their housing investments. Here again, researchers find that the purchase price influences the decision of whether or not to sell a house, with households less likely to sell their house when the market price falls below the house purchase price.
While behavioral biases may be hard-wired in our brains and hark back to simpler times when most decisions were about survival and had to be made quickly, we are making strides to document these biases and learn how to overcome them. With respect to the "sunk-cost fallacy" and the "disposition effect," the lesson to learn is to be forward-looking when evaluating the status of one's investments and remember that the past is irrelevant.
Anna Scherbina is an adjunct scholar at the American Enterprise Institute. She is an associate professor of finance at the University of California, Davis.