The recent market crash has been propelled by a lot of panic selling. Some of it is admittedly justified; those close to retirement or out of work might need to liquidate just to make ends meet. However, much of the market panic undoubtedly comes from the infamous sunk cost fallacy. That is, much of the panic selling is not logically justified.
Before moving further, I have to emphasize that this article, like all of the others on this site, is not financial advice and should not be taken as such. If you need assistance in making an investment decision, please consult with a licensed financial professional.
What is a Sunk Cost Fallacy?
A sunk cost is a cost that has already been incurred and has no way of being recovered. The key point is that they cannot be avoided anymore. A sunk cost is just that: sunk. No matter how much effort you put into something, you cannot make up a sunk cost.
A sunk cost fallacy is considering sunk costs when making a decision for the future. The reason it is a fallacy is because considering sunk costs at all is completely irrelevant to future outcomes. The only thing that someone should look at when making a decision is the future expected benefit of that decision. Looking at sunk costs ignores that rule.
Time is a great example of a sunk cost. If you work on a project for 2 months, and you expect it to take another month to complete, the 2 months that you have already spent are a sunk cost. There is no getting that time back. The time is spent, permanently. The common “well, we have come this far, so might as well finish” sentiment is incorrect. Instead, you should ask yourself whether working one additional month on that project is worth the payoff or whether you should use the time for something else. It’s opportunity cost at its finest.
Market losses are another example of a sunk cost. You cannot change the fact that the losses happened. Should you hang on to an investment? The answer does not lie in the prior week’s losses. The answer lies in the future expected gains.
Does it Make Sense to Panic Sell?
If you are panic selling because you are looking at the market decreases themselves, no, it does not make sense to panic sell. You are focusing on a sunk cost. Deciding to sell because of what the market has already done is a sunk cost fallacy.
Your decision to hang onto a stock or other investment depends entirely on its future expected payoff. A sunk cost is not going to change this. An investment’s future expected payoff is not determined by a sunk cost.
Panic selling only makes sense if you have no where else to go. If you need money because you are going to be kicked out of your home otherwise, then it makes sense to panic sell. Waiting for a 7% average annual return is pretty meaningless compared to having shelter. If you are going to starve without liquidating your investment now to pay for food, then, by all means, panic sell. But are you just intimidated by the last month’s losses? Don’t panic sell.
When to Sell Depends on Your Future Outlook
The only time you should sell an investment, other than necessity, is if the future expected payoff is not enough given your risk tolerance. Even if the market drops 30% in a few weeks, as it occasionally does, does this mean your investment will not bear fruit in the long run?
If you were to start investing again today, would you expect your stock to go up or down based on your investment time horizon? If you are investing to retire 30 years from now, we can pretty safely assume that your investment in a diversified stock market index fund will probably go up on average each year. If you are investing in the hopes to turn a profit 1 year from now, then your decision may look very different.
Before pressing the panic sell button, look closely at your goals for investing and how your current holdings contribute towards those goals. How long do you have left before you want to cash out for good? Does your investment have different risks today than it did when you initially made the investment? Has your personal risk tolerance changed?
Panic Selling Can Be Very Costly
In the case of the stock market, selling in a downturn can be one of the worst decisions possible for the long term. Missing just the 10 best days in the market during a 20-year period can be catastrophic for returns. Missing the 20 best days between 1999 and 2018 would have produced a negative return, as a study by Dalbar illustrates.
Often, the best days occurred within just a couple weeks of the worst days, according to J.P. Morgan. Selling in a downturn will only increase the likelihood that you miss those best days.
On the flip side, timing the market is an incredibly difficult feat in itself. There is little telling what direction the stock market will turn in any given day. It may open extremely low and finish positive. The reverse could also be true. An alarming news story might drastically swing the market in one direction one week, only for it to turn around the next after new stories surface. Is attempting to time the market worth the risk of missing the 10 best days within a whopping 20-year period? Probably not.
By understanding that sunk costs are permanent, you can make sure to focus on future benefits in making your decisions. This approach expands well beyond investing. The cost of something from before is irrelevant. The costs and benefits of staying invested now are the only important considerations.