Know When to Let Go of a Loser

Oh dear. Look at how far some well-known stocks have fallen:

Source: Yahoo! Finance.

Imagine that you'd bought $10,000 worth of Boeing stock at the beginning of the year. Well, you'd own just $4,540 worth of it now. Yikes! Your $10,000 of Gap stock? Just $6,350 now. Gulp.

Here's the way many investors would view this situation: "OK, I'm down 54%. I need to recover that 54% and then I'll start moving into the black on this stock." They remember when Boeing was at $87 per share, and they focus on the loss of $47 per share. That's not the best way to think about it, though.

It is important to look at your investing history in order to glean important lessons. But investing is really a forward-looking enterprise. Your losses are "sunk costs."

That sinking feeling
In economics, a "sunk cost" is money that has already been spent, and it shouldn't factor into your future decision-making. For example, if you bought some tickets for the opera, but then read some bad reviews and changed your mind about going, you might make yourself go, since you already spent the money.

But the money is gone, regardless of whether you go. So if you'd really rather stay home or go to the movies with friends, you should consider doing so. It won't affect your finances.

Yes, you may be down 54% with Boeing. But forget about the $10,000 you started with -- instead, focus on the $4,540 you have left. Don't just blindly plan to sit there and wait for your $4,540 to become $10,000 again. Sure, if Boeing is still one of your most promising investment ideas, then hang in there -- your investment could be worth $8,000 or $15,000 in the future. But there's no need to fixate on the $10,000 figure.  

More importantly, you should always be asking yourself, "Which stocks are the ones I have the most faith in? Is my money mainly in those stocks?" If it isn't, then move it there. Leaving money in a stock you've lost faith in, solely because you lost money and want to earn it back, is silly. You can earn back what you lost by moving the money to a stock you believe has better prospects.

Other sunk costs
Sunk cost is a useful term to keep in mind when you think about businesses in other ways, too. For example, imagine that a company has spent several million dollars looking into merging with another company, and discovers some troubling aspects to the deal. Its CEO might feel nervous about moving forward, but might figure that since so much has been invested in the deal already, he might as well go ahead and merge, and then aim to make the best of it.

That would be a CEO with sloppy thinking. The millions spent are a sunk cost, and they cannot be recovered. They shouldn't influence the decision.

What's behind our thinking when we don't think properly about sunk costs? There are two key things going on.

First, we fixate on the price we paid. We should instead focus on what we have left, and how best to deploy or invest it.

Second, we are heavily influenced by our aversion to losses. We don't want to have to say that we lost half our money on Boeing, or that we spent millions looking into a deal we nixed, or that we "wasted" the money we spent on the opera tickets. So we sometimes make suboptimal decisions.

Don't let sunk costs sink the rest of your portfolio. Make the right choices with what you have left and you'll end up a better investor.