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Monday, 22 September 2014

A-Rod, the Yankees and a lesson in sunk costs

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The New York Yankees and their ageing and highly paid third baseman Alex Rodriguez illustrate a problem all investors face and few completely conquer: sunk costs.

James Saft, Reuters Columnist

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 US$29m in 2012.

What’s worse, they’ve got another US$114m 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 realised - 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 US$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 US$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 realised 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 rationalise that they are simply ’early’ rather than wrong. That is, as long as they don’t crystallise 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 realise 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 realise 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.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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