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Is value investing more susceptible to sunk cost fallacy?


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One mistake I repeatedly notice from value investors (from both people in this forum and people that I know) is what seems to me the sunk cost fallacy. And I don't mean just not being able to get out of investments that are in loss, but rather due to the time/effort spent. Basically, you need to spend a significant amount of time and effort to study a company and compute the intrinsic value for the company. In fact, you spend more time/effort so that you can increase your confidence in the decision you are going to make -- whether to buy or not buy a particular investment. If you have decided to buy it (and share the investment idea), very rarely you change your mind... even against well-formed criticisms or unfolding events that are counter to your original thesis. You get stuck in the hole that you have dug.

 

At the same time, you do need some conviction to stay committed to your idea and ride out the market volatility. If you had no "bias" at all, you will simply sell at the slightest price movement, bad news, or criticism. Also, you do need to inevitably spend time/effort in studying your potential investment.

 

How do we balance this? Do you have any checks/methods to identify your own sunk cost bias?

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I think this is actually where value investing shines: you actually have to learn the business. Maybe you take losses initially due to the factors you mention. But maybe in 3 years you can come back and now the investment decision is easier because you have built up knowledge. The biggest “value” is this built up knowledge.

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There should be no sunk in cost. It should all come down to putting in the work, doing your homework, keeping on top of things. There are no real tricks. Just like every other job there are got investors and not so good investors.

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Only in the stock market do these things exist and they exist simply because you can check stock prices daily. If you know the business well it's pretty cut and dry. If you're a sole proprietor and you keep having to invest new capital, eventually you realize its a lost cause and close shop. If you see the business grow and start seeing cash on cash returns, you know you've got a good one. When you can internalize these things as the owner of a publicly traded company, you're where you should be. If you get nervous just cuz the stock goes down, stick to index funds...

 

 

If you are an investor in individual companies, you should be able to discern "health of the company" from "stock price gyrations".

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Predicting the direction of a sub-index is a lot less work, easier, and more reliable; than predicting the direction of an individual security. Hence for most 'value' investors, 'index' investing will generate the better return/hour spent, and you spend your tiime on capital allocation versus stock picking.

 

However, people being people, seek 'confirmation' from others; and people brag of their stock 'winners' at parties - not their capital allocation. Hence 'value investors' typically stock pick, in large part, to rank well in a popularity contest. Something very far away from the commonly accepted definition of a 'sunk' cost.

 

SD

 

 

   

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I think there are two problems:

1. Sunk cost: The more time I spend researching a stock, the more likely I'll increase my confidence without increasing my batting average.

2. Opportunity cost: The more time i spend researching one stock, the less likely I'll have time to research other stocks and compare to find the best ones.

 

Therefore, I keep a chart of time spent researching stocks and batting average increase and try to find the best balance.

Eventually I decide that I should only spend 5 minutes per stock and additional research time isn't useful for me.

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I disagree about the opportunity cost because once you learn about a particular stock or business, well that knowledge doesn't go away. Five years later you can use most of it to make a trade decision. So now five years later you can spend that time researching stock Z

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I think there are two problems:

1. Sunk cost: The more time I spend researching a stock, the more likely I'll increase my confidence without increasing my batting average.

2. Opportunity cost: The more time i spend researching one stock, the less likely I'll have time to research other stocks and compare to find the best ones.

 

Therefore, I keep a chart of time spent researching stocks and batting average increase and try to find the best balance.

Eventually I decide that I should only spend 5 minutes per stock and additional research time isn't useful for me.

 

To me, this strategy somehow resonates with Buffett's stories about how he likes to go through the entire Moody's manual or how he makes a decision to buy / make an offer to a business in a short amount of time (he doesn't need to drag along).

 

On the other hand, I wonder how much the sunk cost bias had contributed to the famous mistakes like Ackman's Herbalife short or Pabrai's ZINC bet... again not just due to the monetary loss but due to the time/energy that they spent on those investments.

 

 

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A bunch of problems would be solved if you can categorize your investments into buckets. Each bucket would have a different approach in terms of position sizing, how much margin of safety is needed, how much research is needed, how long you hold, etc.

 

The way I categorize is

 

1) Businesses with strong moats and which grow value above the broad stock market.

 

2) Businesses that either with weak moats or grow value at or below market rate.

 

3) Special situations: Spinoffs, Merger/Arb, etc.

 

 

For 1), you can identify the business upfront and research them at your convenience. Then update them every 6 months. The advantage is that, these business change infrequently and your knowledge is cumulative. In addition, market throws a fit at least for a couple of these stocks each year for some odd reason. Since you already did your research you just need to do a quick update and make a decision. This is a pretty good area for me personally. Less bias due to the issues you mention, as I have already researched them a long time back and I have a price point in mind. I have about 80 stocks in this bucket and own about 12 of them. No sunk cost fallacy here as I have several dozens that I have researched already and waiting to be replaced as needed.

 

For 2) and 3) you pick your spots. You lean about a few industries and if a business happens to fall under them, it would not take too long to get up to speed. If it is not an industry you are competent in, I do not think I have the time to get up to speed on the industry and the business in quick enough time to make a buy decision. The key being picking your spots and not going after those you have little idea about.

 

For example, energy is probably a productive area for investment now, but it is not an industry that I am competent in. So I do not bother researching it now, since it would take me too long and by that time the opportunity would have disappeared.

 

Chasing after ideas is tough, it is better to let them come to you. Avoids a whole bunch of issues, including sunk cost fallacy.

 

Vinod

 

 

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Taking a quick look at my portfolio, there are only 3 businesses that I have researched in the last 15 months. Not one of the businesses that I researched in the last 6 months made it into my portfolio.

 

Vinod

 

I think having that expectation in mind before you start your analysis is key.

 

1. Having the mindset that most of the businesses you'll look at will be rejected on the basis of business quality or your ability to understand and value it (unless you're finding them by looking at the picks of other great investors who may have filtered your list for quality already). Your work has still been valuable if you've avoided a mistake and rejected something that doesn't put the odds strongly enough in your favour, either ever, or at least at its current price. It may also give you insight that you can carry into future analyses that will benefit you later.

 

2. Having the mindset that you will value it independently of its market price and insist upon a wide margin of safety before buying, so that you're likely not to find it at a price you're willing to pay and you'll to have to wait until the market goes crazy and beats it down excessively to a good discount before you take a large position.

 

3. A possible exception to 2. is companies of the Phil Fisher type where you have high conviction they will compound at high rates for a decade or more beyond what's priced into the stock and you have the benefit of time-frame arbitrage in your favour due to your long time horizon and doggedness in holding on despite market peaks and troughs. Perhaps the likes of Amazon and Alphabet/Google fit this, at least in the past. Even with those, it's often best to wait until they have a temporary setback and get repriced as if they're not going to grow as fast before you really commit large sums to them, especially if you have some relatively recent history of such setbacks as a guide to the typical valuation ratios available at such times. There is of course the chance you'll miss out.

 

4. A few companies will be those you haven't analysed deeply yet, but you become aware that they've been surprisingly cheap for a little while on the surface and may be worth investigating to see if you feel you can value them and decide how much you could risk in taking a position. You'll probably still have some days or weeks to try to get an understanding of the business before the price changes significantly (especially if you know that major earnings releases or product launches that might spark a re-rating aren't imminent). If you can still manage to assess them honestly, and overcome the fact that you have a strong inkling in advance that they're undervalued, these can be the times when your research effort can result in a fairly swift decision to purchase a truly meaningful position at the current price and can have a substantial impact on your future wealth.

 

 

Essentially, don't forget the idea of having a punch-card allowing you only 20 trades in your investing career. If you had such a restriction, you'd focus on your best ideas in sound long-term businesses when you consider they're deeply undervalued and thus have a low risk of permanent loss of capital and a high prospect of substantial gains. And being limited to 20 trades, you'd put a meaningful proportion of your portfolio into such positions. For me, with the time I devote to it and my limited circle of competence, these sort of high conviction ideas are truly rare - perhaps just a few in a decade or two.

 

 

There's one stock that was getting to around 10% above my large-margin-of-safety target buy price very recently (a price that should provide an OK return even if the business languishes for the next 5-10 years, so long as it doesn't decline too fast). It has since recovered a little along with the general market and is now about 20% above my target. It might fall again in the coming months and reward me for my patience, or I might miss out on an opportunity to obtain perhaps 40-80% total return over maybe the next 2 to 4 years, versus maybe 50-100% total return if I do get it at my target price.

I could have potentially benefited a little from my willingness to purchase a little below the recent market price by writing some put options at my desired strike price in the style of boilermaker75 (either keeping the premium or getting the stock if the price falls enough to get put to), but as it happened, the tax-free account where I had the funds available to deploy doesn't allow me to use options, so I missed out on that specific opportunity on this occasion (though if I can buy it eventually at my desired price and reap 50-100% gains in 2-4 years without capital gains tax, I'll more than make up for the short term 1-2% gain from writing the puts that I have foregone).

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Guest cherzeca

I think there are two problems:

1. Sunk cost: The more time I spend researching a stock, the more likely I'll increase my confidence without increasing my batting average.

2. Opportunity cost: The more time i spend researching one stock, the less likely I'll have time to research other stocks and compare to find the best ones.

 

Therefore, I keep a chart of time spent researching stocks and batting average increase and try to find the best balance.

Eventually I decide that I should only spend 5 minutes per stock and additional research time isn't useful for me.

 

To me, this strategy somehow resonates with Buffett's stories about how he likes to go through the entire Moody's manual or how he makes a decision to buy / make an offer to a business in a short amount of time (he doesn't need to drag along).

 

On the other hand, I wonder how much the sunk cost bias had contributed to the famous mistakes like Ackman's Herbalife short or Pabrai's ZINC bet... again not just due to the monetary loss but due to the time/energy that they spent on those investments.

 

Ackman's Herbalife short was right and he was vindicated by ftc...but he lost money. how's that?  not a question of sunk cost, more a question of pursuing a strategy that required a govt bureaucrat's assistance.

 

I view sunk cost as a brute and blunt analytic metric that is based on 20-20 hindsight.  I think it is better to observe a few filters, as Buffett calls them, distilled from experience.  apply your filters before you sink in your costs, and leave "sunk cost" regret analysis by the wayside.  you can be wrong, but not because of your sunk costs, but because your filter weren't up to the task

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