Escalation of Commitment and the Sunk Cost Fallacy

Escalation of commitment, often referred to as the sunk cost fallacy, is one of the more detrimental cognitive blind spots that affect trading performance.

Essentially, the sunk cost fallacy and escalation of commitment refer to the way we increase our level of commitment to a prior choice, even when that increase is not the optimal course of action. Rather than seeing the cost of that choice as sunk (i.e money spent) we tend to continue to pursue a particular path in order to justify the earlier choice, rather than recognising it as a mistake and changing course.

We are vulnerable to this fallacy in all areas of our lives. You've surely had the experience of forcing yourself to finish a meal that you've paid for, even when you don't really want to eat any more, or continuing to read a book when even after 200 pages you're not enjoying it. In Misbehaving: The Making of Behavioural Economics, professor Richard H. Thaler uses the following example to illustrate the sunk cost fallacy:

'Vince paid $1000 to an indoor tennis club that entitled him to play once a week for the indoor season. After two months he developed tennis elbow, which made playing painful. He continued to play in pain for three more months because he did not want to waste the membership fee. He only stopped playing when the pain became unbearable.'

This perfectly demonstrates how a perceived loss can cause a person to act in a completely irrational way, which is far more detrimental in the long run than accepting the membership fee as a sunk cost and moving on. In all likelihood, as Thaler comments, if a friend had invited him to play tennis for free at a different tennis club he would have turned down the invitation, citing the injured elbow as the reason.

Chess is another particularly good example that takes us slightly closer to the world of trading. Imagine that during a game of chess you manage to gain an advantage over your opponent. You work to nurture that advantage, putting your opponent into an increasingly difficult position, but along the way you make an error of judgement and give up that advantage by losing an important piece. Many players will still be so unconsciously committed to the old strategy that they will fool themselves into thinking they still possess the advantage it was based on and keep playing in that manner even though the situation on the board has changed. This persistence regarding a reality that is no longer true will cause them to unconsciously miss opportunities that don't fit into that particular strategy and will eventually cause them to make further mistakes that put them at an even greater disadvantage. What's happening here is they are refusing to recognise the reality of the current state of play and are stuck in the past where they really did have an advantage over their opponent.

It's the same in trading. We often enter a market with a clear strategy in mind, then begin to ignore all the indications that suggest we may have made an error of judgement, clinging to the ideas that led us to make the trade as it continues to move further and further out of our favour. Sometimes a strategy will show signs of working, but then for whatever reason the market changes direction and being so married to our theories, we ignore the reversal and sit there expecting the price to go back in our favour. Part of the reason for this irrational behaviour is that human beings feel perceived losses twice as intensely as perceived gains, which means we are almost programmed to ignore a trade that is rapidly spinning out of control in order to avoid closing it at a loss. We have no problem closing winning positions too early, because even if we have lost potential profits by doing so, our mental accounting allows us to score the trade as a win.

Another thing to keep in mind is that sunk costs are felt less over time. Thaler demonstrates this with an example from a study conducted by Gourville & Soman, who looked at gym attendance and found that it spikes just after members receive their bills and then gradually drops again as time passes and the cost of the membership is no longer so much of a concern. So the bill comes in and you suddenly realise that you have to extract the worth, or utility, of the membership, so you start going to the gym again regularly, only to revert to your old lazy ways as time goes by and the money you paid starts to slip from memory. In other words, the longer you let your losses run, hoping for the market to change direction and allowing you to close your trade at a profit, the more accustomed you become to the new situation (having less available equity) and the closer you are to some sudden price move wiping out your account. This is partly why so many traders blow up their accounts and then start fresh with new money only to repeat the process.

As with all the material in this trading psychology section, the aim is to get you thinking about the unconscious behaviours you exhibit while trading, in the hope that your awareness of them will lead you to reduce their effects. Whether this be by setting strict stop loss and take profit levels, or having a rigorous plan before entering the market and the discipline not to deviate from it in the heat of the moment, is up to you. Awareness of unconscious behaviours is the first step to correcting them.

Did you know?

Many consider the year 1880 A.D. to mark the beginning of modern foreign exchange. The reason for this is that it was during this year that the gold standard was first introduced.

Word of the day
"Wedge" - A chart pattern that indicates trend reversal.
Pro Tip

Always keep a record of all your transactions.