How the sunk cost fallacy can derail your trading

Dear Traders,

Did you ever hold on to a trade, even though a loss seemed likely?

Well, don't worry:

...you are not alone.

All traders are victims of this problem at some stage - so much so, that it has it's own name i.e. sunk cost bias.

The sunk cost bias explains why humans tend to commit to past decisions, over the best future benefit.

This problem can cause havoc for your trading account.

The good news is, I'm here to help you fight this trading weakness.

Not only will this post explain why traders stick to bad decisions:

...it will also provide clear steps on how to change your thinking and become more rational in your choices.

What is sunk cost fallacy?

Renowned entrepreneur Rolf Dobelli did a great job of explaining the sunk cost bias, in his book The Art of Thinking Clearly.

I'll try to summarise his findings.

Basically, he says it all comes down to human nature.

Traders are human beings first, so they tend to justify their decisions using past events.

Let me give you an example.

Do you ever keep stuff like papers or clothing, even though you know you will never use them again?

Or maybe you have a struggling project that requires more and more resources, despite the low odds of success?

Both situations are textbook examples of the sunk cost bias.

Our inability to let past things go, clouds our judgement and makes it difficult to take action.

For traders, this bias translates into focusing on past costs and efforts, when making current trading decisions.

In short, the sunk cost fallacy explains why some traders:

1. rely on luck
2. tend to ignore new information
3. find it difficult to accept even a small loss.

Does sunk cost fallacy impact your trading?

Short answer - yes.

Traders refer to sunk cost bias as throwing good money after bad money.

Again, it means traders hold on to a trade because they are not willing to change their view and accept a loss.

Traders struggle with sunk cost because they:

1. have a strong sense of avoiding losses
2. create a commitment to an open trade setup
3. exaggerate potential benefits from their open trades
4. want to prove that their initial decision made sense
5. prefer not to admit that a trade was a waste of time
6. fear regret
7. ignore the potential opportunities
8. have unrealistic profit expectations
9. think their image will suffer if they change their decision too soon.

The above reasons explain why proper trade management and exit management, are such a difficult part of trading.

Incidentally, if you have been to our live webinars then you probably already know that Nenad and I often mention this issue.

How to avoid the sunk cost fallacy?

Psychological blocks are by far the hardest things to overcome.

But there is good news:

...you can significantly reduce sunk cost bias…

...if you become consciously aware of this fallacy.

There are many ways to improve your awareness.

You can try meditation, breathing exercises or slowing down your decision-making process.

Quick decision making is often an enemy of critical thinking.

Additionally, there are questions you need to ask yourself.

1. What would I recommend to a friend if they were in the same trade?
2. Am I sacrificing other good trading opportunities that I'm not aware of?
3. Have the parameters of the trade setup changed?
4. Is there new information that makes the trade less desirable?
5. Am I simply trying to prove myself right and the market wrong?

After all, optimal trade management is just a matter of asking the right question at the right time.

Don't get me wrong, I am not advocating closing trades on every emotional whim.

But it goes without saying that traders should formulate their own trade management plan.

This plan should help remove past fears and make you more focused on future benefits.

For starters, take a look at our video below to learn more about profit stops.

How long does it take to learn this?

Learning to avoid sunk cost fallacy is a gradual process that requires practice and patience.

Take the time required to understand these points and apply them.

Cheers and safe trading,

Chris