SAFT ON WEALTH:A-Rod, the Yankees and a lesson in sunk costs

November 1, 2012

Nov 1 (Reuters) – - The New York Yankees and their aging and
highly paid third baseman Alex Rodriguez illustrate a problem
all investors face and few completely conquer: sunk costs.

You too, like the Yankees, probably own a security you paid
more for than it is now worth, and you too may well find it
perplexingly hard to sell and accept your loss.

Rodriguez, for those of you who don’t follow baseball, is a
likely hall of famer whose skills, at least based on the
statistical record, have slipped sadly recently. Things came to
a head in the baseball playoffs when the Yankees benched
Rodriguez, the man they will pay $29 million in 2012.

What’s worse, they’ve got another $114 million to dole out
to Rodriguez on a contract that only expires after the 2017
season, at which point he will be 41 years old.

The sensible thing would be for the Yankees to cut their
losses, sending him along with a packet of cash to a team in
exchange for what they can get and the right to use his roster
spot better. Unfortunately, that may prove very difficult for
the Yankees – the richest team in baseball – to bring themselves
to do.

Aswath Damodaran, a professor of finance at NYU and a
specialist in value investing, argues that the Yankees, like
investors everywhere, are struggling to come to terms with the
psychological difficulty of acknowledging sunk costs.

“The problem is that investors seem to have different sets
of rules, one for new or marginal investments, and one for
existing investments. Rationally, your decision on whether to
keep an investment in your portfolio should be based on whether
that investment is cheap or expensive, given its price and value
today, and not on what you originally paid for the investment or
its value then,” Damodaran wrote in his blog.

Operating rationally, sunk costs – that is, anything you’ve
paid or committed to and can’t be realized – should be ignored
in any analysis of what to do with an asset or any other type of
investment. A mining company which has spent $100 million
digging unsuccessfully for rare earths should ignore those sunk
costs in deciding whether or not to continue with the exercise,
focusing instead on information that indicates how likely any
new money spent is to be justified with ore.

In the same way, the fact that you bought Facebook
just after the IPO, paying $38 per share or more, gives you
absolutely no information about whether it is a buy, sell or
hold now that it changes hands at about $21 per share.

LOSS AVERSION AND THE DISPOSITION EFFECT

In theory an investor should focus on his or her own
analysis of value and the price which can be realized now for a
security, while – of course – being mindful of the tax
implications of any trade.

So why is it that we become overly identified with our
investments? Part of it, surely, is that our own egos are on the
line in our past decisions, and investors rationalize that they
are simply ‘early’ rather than wrong. That is, as long as they
don’t crystallize a loss with a sale.

Research by psychologists Daniel Kahneman and Amos Tversky
going back to the 1970s demonstrated that losses had a much more
powerful effect on subjects’ emotions than gains, with a power
ratio of about 2:1. So in part this phenomenon of loss aversion
explains a reluctance to realize losses. That leaves many
investors waiting for years or indefinitely for a security to
get back in the black. Those investors are totally ignoring the
many other possible ways in which that capital could be deployed
more profitably.

Researchers Hersh Shefrin and Meir Statman built on this
work, studying the disposition of investors to sell winners too
early and ride losers too long. They found real-world evidence
of both which could not be explained solely by tax-induced
selling, attributing it in part to a tendency to seek sources of
pride and avoid sources of regret.

Of course, this phenomenon is not limited to investors.
Companies constantly carry through with large investments even
after they are obviously doomed. The Edsel and the Concorde are
just two examples. What makes loss aversion and the sunk costs
fallacy so striking in investors is that – unless they are not
money managers – it is their capital on the line.

An executive may have staked his reputation, and hence
future employment, on the success of a project and may carry
through with it because it is not his money going down the
tubes. A similar phenomenon might be in play with money
managers, who may not want to look bad to clients or the
investment committee by fessing up about those Facebook shares.

But for the rest of us, ultimately, you have to remember:
the universe doesn’t care what you paid for a stock.

Take that in, and realize that what you paid has no
predictive value of what a stock will do in the future. Further,
the universe has seen bigger fools than you come and go and will
not notice if you acknowledge the fact, dump those Facebook
shares, and get on with your life.

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