Some psychologists refer to the psychological biases that effect the way we act as judgemental heuristics. Judgemental, because they affect our decision making processes, with heuristics being shortcuts that allow us to sift through and sort out information in a short period of time.
So, what is the sunk cost effect?
In the world of economics, sunk costs are costs which have already been incurred and therefore lost for good.
The sunk cost effect is the tendency human beings have to consider the amount of money already spent when making a decision.
An example of the sunk cost effect
As an example, let’s say you’ve spent £1,000 on a pair of box seats to go and watch Manchester United.
However, on the day of the game you have a genuine flu. Every part of your body aches. You desperately want to stay in bed. You know how it is.
A rational and logical approach to this would be to completely disregard the money that has been spent and weigh up the pros and cons of dragging yourself to the game and probably not enjoying one minute of it or staying at home where you’ll be more comfortable. The rational outcome being that you stay at home.
However, the sunk cost effect causes decision makers to put too strong a meaning on the money already spent. It causes a decision maker to go to the game regardless of how they feel because they have spent £1,000 on the tickets.
The sunk cost effect and trading
How does this example lend itself to trading psychology?
Well, let’s suggest a person new to spreadbetting has a £1,000 account and takes out a long position in a popular UK stock. Let’s go for Vodafone for no reason other than it’s a well known and heavily traded UK stock.
Now let’s suggest that this new spreadbettor enters that trade at £1 per point with a 100-point stop loss. They are therefore risking £100 on the trade as this is the amount they will lose if their stop loss is hit.
After a few days pass, the price of Vodafone has fallen by 50 points and they are therefore £50 down. A few more days pass and the price falls down to -100 points. They are now £100 down and have lost 10% of their account in this one trade.
Consider how the sunk cost effect might affect that trader’s decision to at this point lower their stop loss and give the stock even more room. They have already committed 10% of their account to this trade.
The sunk cost effect will influence the trader’s rational thinking. Instead of staying committed to their previously designated exit the trader may look for ways to avoid wasting the £100 already spent on the trade by lowering their stop. The question then is what the trader does when their position falls to a -£200 loss.
Sunk costs and downward spirals
As you can see, it can often be a downward spiral. The longer the trader holds their position the more they are at risk of losing to the trade and this is one of many ways new traders can find their accounts disappearing very quickly.
What was initially a potential £100 loss has turned into a potential £200 or even £300 loss (30% of their account).
This is until the trader finally gives in from sheer panic and distress and finally closes the trade!
The way to avoid all of this is of course to pre-define your exit before you even place your trade and then, even more importantly, stick to this plan.
Overcoming these psychological barriers which affect your trading can have a significantly positive effect on your long term performance as a trader Spreadbetting the financial markets.