Know When to Cut Your Losses

It was the spring of 2010. I had arrived in Vegas early on a Friday morning for a bachelor party. All of my friends, having come in the night before, were asleep in the casino hotel. Last time I was there, I'd gone home with a nice chunk of change; I was looking to reproduce the result.

And yet, after an hour at the blackjack table, I was down $200. "No problem," I said to myself confidently, as I strode to the ATM machine to take out $200 more. "My luck will soon change."

The problem is, it didn't. I had deluded myself into thinking that winning was a sure thing. I ignored the fact that long-term trends were on the house's side, and kept upping my bets along the way. By the time my friends awoke, I had lost a lot of money.

There's a name for my problem that day in Vegas: escalation of commitment. Over the past week, I've been investigating lots of different biases. Today, I'll tell you how escalation of commitment can hurt you, and what you can do about it.

Escalation in the investing world
Simply put, an error in decision-making -- by way of an escalation of commitment -- occurs when a person decides to invest more money into a company to justify a past investment decision. I learned this lesson the hard way with Rosetta Stone (NYSE: RST  ) .

One of the other jobs I take on at the Fool is offering my opinion on what stocks should be deemed "Best Buys Now" for Stock Advisor. I had written heavily in 2010 about why the stock should succeed, and I kept thinking it deserved a spot on the list. At the same time, I kept adding it to my personal portfolio.

The problem was that performance had deteriorated. I wasn't paying close enough attention to this; I ignored the fact that the company wasn't penetrating certain markets, and that there were serious issues in the executive suite. 

It wouldn't have been so bad except for the fact that I had kept escalating my investment. Eventually, my total position was five times my initial investment. When all was said and done and I sold in late 2011, I had lost 55% of my investment.

How I'm learning from this
These days, I work hard to combat this tendency. As I've said in my articles on other biases, the key is to admit daily that there's more that you don't know than that which you do. For this bias in particular, it's helpful to ask yourself: Would I invest in this now if I had never invested in this before?

Hopefully, these simple steps can eliminate a lot of problems.  If you think you've got the bias under control, consider checking out our top pick for 2013.

Our chief investment officer has selected his No. 1 stock for the next year. Find out which stock it is in our brand-new free report: "The Motley Fool's Top Stock for 2013." I invite you to take a copy, free for a limited time. Just click here to access the report and find out the name of this under-the-radar company.


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10/24/2014 4:01 PM
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