Avoiding the Sunk Cost Fallacy While Trading

Avoiding the Sunk Cost Fallacy While Trading

In our most recent article about the sunk cost fallacy, we illustrated the sunk cost fallacy with a story about buying a used car. But, since we’re not standing in a parking lot surrounded by wacky inflatable tube men, you’re probably more interested in how it applies to trading strategies.

The sunk cost fallacy is what happens when you’re unable to reframe a decision about the future as time passes. Overcoming it – and becoming a more effective trader – comes from practice. You have to get in the habit of reframing decisions as time passes, weighing new information against what let you to invest in the first place. Here are 4 tips to help you get in the habit.

1) Call a loss a loss.

It’s not the end of your trading career. It’s not financial ruin. If you continue to learn, you will spot more opportunities. You’ll get better at spotting them, too. But, if you never question your decisions, you’ll never improve. So, when an investment results in a loss, keep your head up and look out for the next opportunity. (Note: this doesn’t mean “set an aggressive stop loss.” It means that if you’re shown to be wrong, don’t double down. Get right.)

2) Be a scientist.

Scientists don’t predict what will happen when two chemicals mix. They explain why the chemicals will react a certain way, then ruthlessly test several possible explanations: hypotheses. They subject them to double-blind studies, peer reviews, statistical analysis and more. Think of your trading the same way. You’re not testing if a security will go up or down. You’re testing if your strategy will produce returns.

Instead of asking yourself about individual moves, (“Why isn’t this moving like I predicted?”, “How did I miss that obvious signal?”) make a point to question how your trading strategy is formed:

Do you trade better with more trade alerts, or fewer?

After a lucky break, do you get cocky on the next trade?

Are you waiting to move because you need more info, or because you’re just unsure?

3) Instead of examining charts, examine your head.

A stock chart is a simple way to examine the past – and only the past. For inferencing about the future, your brain – or, in some cases, a computer – has to fill in the gaps. Next time you’re looking for future clues in past data, pause and ask yourself, “How is this new information influencing me?” and “Why am I putting my trust in this?” By questioning decisions instead of just making them, you can override your instincts. Or, as we like to say: “Instead of leaning in closer, step away from the screen.”

4) Change your framework.

In the car analogy from yesterday’s blog post, the buyer came across as impulsive, irrational even. But we have the luxury of an outsider’s perspective. While his reaction may seem extreme, it can seem perfectly sane when you’re the one in the driver’s seat – or trading platform.

So, the trick is to be always setting yourself up for success, well before you actually need to make the decision to buy or pass, hold or sell. By changing your data sources and reading habits, writing down your strategies, talking through plans with an advisor, or even offloading some decisions through algorithmic trading, you can take control of your decision making. Sure, it’ll take some time to get started, but it’s safe to say you can consider that a sunk cost.

Learn more about fractalerts. Fill in the form on our home page and a member of our team would be happy to give you a call or engage via email. Follow our trades. Leave the math to us. To simply learn more about our process, check out our “The Science” page.

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