Sunk Cost Fallacy
Overview
The sunk cost fallacy occurs when traders continue holding a losing position or investing additional capital because of the resources already committed, rather than evaluating the position on its current merits and future prospects. The time, money, and emotional energy already spent become anchors that prevent rational decision-making, leading to escalating commitment to failing trades.
Key Concepts
Sunk costs are past expenditures that cannot be recovered regardless of future actions. Rational decision-making should only consider future costs and benefits, not past commitments. Traders fall into this trap by averaging down into losing trades without new analytical justification. Emotional investment in a trade thesis makes abandoning it feel like admitting failure. The fallacy is amplified when the trader has publicly shared their position or analysis. Opportunity cost: capital locked in a losing trade cannot be deployed in better opportunities.
Entry Signals
Before averaging down, ask whether you would enter this trade fresh at the current price with no existing position. Treat every moment as a new decision: is the expected value of holding positive from this point forward? Set a maximum number of additions to a position and a maximum total allocation before the trade begins. Document the specific conditions that would invalidate your thesis before entering.
Exit Signals
Exit when the original thesis is invalidated, regardless of accumulated losses. Close positions where the only reason for holding is the amount already lost. Review positions weekly and ask: if this were cash, would I choose to invest it here today? Set a maximum drawdown per position that triggers automatic closure.
Best Timeframes
Ongoing — applied to every position review and evaluated weekly
Pro Tips
The most effective defence against the sunk cost fallacy is reframing every position as a new decision each day. Ask yourself: given everything I know now, would I enter this trade today at this price? If the answer is no, the rational action is to close the position immediately, regardless of past losses. The past investment is irrelevant to the future expectation.
More Topics in This Category
Mental Accounting
Mental accounting is the cognitive bias of treating money differently based on its source, intended use, or the mental 'account' it is assigned to — even though all money is fungible. In trading, this manifests as treating profits differently from initial capital (risking 'house money' more freely), segregating portfolio performance by position rather than total, or taking excessive risk with bonus or windfall funds.
Recency Bias
Recency bias is the tendency to overweight recent events and outcomes when making decisions, while underweighting longer-term data. In trading, this manifests as assuming recent market conditions will persist indefinitely — expecting further gains after a rally or further losses after a crash. Recency bias creates a dangerous feedback loop where traders chase recent performance rather than evaluating current probabilities objectively.
FOMO & Herding Behaviour
FOMO (Fear Of Missing Out) drives traders to enter positions impulsively because they see prices rising or because social media is buzzing about an asset. Herding behaviour — following the crowd — amplifies FOMO by creating social proof. Together, these biases cause buying at tops and chasing momentum that's already exhausted.
Overconfidence Effect
The overconfidence effect causes traders to overestimate their knowledge, skill, and ability to predict market outcomes. After a winning streak, traders often increase position sizes, ignore their rules, and take trades that don't meet their criteria — believing they have a 'hot hand'. Overconfidence typically precedes the largest drawdowns in a trader's career.