Have you ever made yourself suffer through a bad movie because after paying for the ticket or rental you just had to get your money's worth? Some people invest the same way. Behavioural economists have a name for the tendency of people and organisations to stick with a losing strategy only because they have put so much time and money into it already. It's called the "sunk cost fallacy". The motivations behind the sunk cost fallacy are understandable. We want our investments to do well and we don't want to believe our efforts have been in vain. But there are ways of dealing with this challenge. Here are seven simple rules:
- Accept that not every investment will be a winner. Shares rise and fall based on news and on the markets' collective view of their prospects.
- While risk and return are related, not every risk is worth taking. Taking big bets on individual shares or industries leaves you open to idiosyncratic influences like changing technology.
- Diversification can help wash away these individual influences. Over time, we know there is a capital market rate of return. But it is not divided equally among shares or uniformly across time. So, spread your risk.
- Understand how markets work. If you hear on the news about the great prospects for a particular company or sector, the chances are the market already knows that and has priced the security accordingly.
- Look to the future, not to the past. The financial news is interesting, but it is about what has already happened and there is nothing much you can do about that.
- Don't fall in love with your investments. People often go wrong by sinking emotional capital into a losing share that they just can't let go.
- Rebalance regularly. This is another way of staying disciplined. If the equity part of your portfolio has risen in value, you might sell down the winners and put the money into bonds to maintain your desired allocation.
This approach may not be as interesting. But by keeping an emotional distance between yourself and your portfolio, you can avoid some unhealthy attachments. These are simple rules. But they are all practical ways of taking your ego out of the investment process and avoiding the sunk cost fallacy.
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