VIDEO: Retirement Investing Pitfall #7 – Prospect Theory & The Sunk Cost Fallacy

 

In this video, we are going to touch on the retirement investing pitfall #7, referred to as Prospect theory. Prospect theory centers on the interesting financial behavior that if two equal choices are put in front of an individual, one presented in terms of potential gains and the other in terms of potential losses, investors are typically more focused on the potential gains vs avoiding losses.

Here’s where things get interesting…after a loss, this typically then results in what is often referred to as loss aversion, which makes investors reluctant to sell an investment they have a loss in, until it returns to breakeven or better. As you can imagine, this can often be a suboptimal approach to managing investments. According to prospect theory, losses can actually have more emotional impact than an equivalent gain. Let me give you an example of this in motion…one would think the benefit gained from receiving $50 should be equal to a situation in where you gained $100, and then lost $50…right? In both situations, the end result is a net gain of $50. However, despite the fact that you still end up with a $50 gain in both cases, most people view a gain of $50 more favorably, than gaining $100 and then suffering a loss of $50.

Now, another investor tendency explored by prospect theory is called the sunk cost fallacy. This refers to an approach that results in investors continuing to put money into a losing investment, in effect, throwing good money after bad. This is even in the face of negative company or sector news, on the assumption that the investment will eventually come back, and at a lower cost basis, due to the added investments as it was falling. Based on this theory, an investor might be better served “throwing in the towel” and walking away, instead of letting their emotions get the best of them and continuing to follow a down trend with the hopes of it turning around.

Prospect theory and the sunk cost fallacy can adversely affect your investment returns if you are not careful. Perhaps, sitting down with an advisor to review your portfolio could help shed some light on what you are doing, and why you are doing it, and make sure you are carefully thinking through your decisions and not potentially sabotaging your nest egg. I feel like I could talk about this topic for days, since I see it often. If you are unsure about risks you might be taking with your investments, like the sunk cost fallacy, give us a call and we’d be delighted to perform a complimentary analysis on your investment accounts to ensure you have a disciplined approach to your retirement.