Loss aversion and the sunk cost trap: 7 deadly sins of investing

Plato Investment Management's 7 deadly sins of investing series continues this week, with the spotlight turning to loss aversion and the sunk cost trap.

This follows Part 1 & Part 2, written by my colleague, Plato Global Alpha Fund Portfolio Manager Dr David Allen, which you can read here.

Education

Seven deadly sins of investing: Part 1

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Education

Seven deadly sins of investing: Part 2 - The hot-hand fallacy

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Let's dive into this third deadly sin. 

A thought experiment

The deeper force at work here is loss aversion. 

Nobel Prize winners Daniel Kahneman and Amos Tversky demonstrated in their 1979 paper on prospect theory that we do not weigh gains and losses symmetrically. 

Losing $100 feels roughly twice as painful as gaining $100 feels good. This is not a quirk of the unsophisticated. It is hardwired into how our brains evaluate outcomes.

For investors, this asymmetry creates two damaging habits. We hold onto losing positions too long, because selling forces us to confront the pain of a realised loss. And we sell our winners too quickly, locking in the pleasure of a gain before the market can take it away.

Try another quick one. Note your gut reaction.

You are offered a coin flip. Heads, you win $150. Tails, you lose $100. Do you take the bet?

The maths is clearly in your favour, but most people refuse it. The potential pain of losing $100 outweighs the pleasure of gaining $150. That is loss aversion in action. Now imagine that dynamic playing out across an entire portfolio, on every position, every day.

The disposition effect

Behavioural finance researchers call this pattern the disposition effect, and it has been measured extensively. In a 1998 study, Terrance Odean analysed the trading records of 10,000 individual investors at a US brokerage and found that a stock sitting at a gain was roughly 50% more likely to be sold than one sitting at a loss. 

Worse, the winners those investors sold went on to outperform the losers they kept by an average of 3.4% over the following year.

Think about what that looks like in practice. 

Millions of Australians bought Telstra in the T2 float at $7.40. Over the years that followed, the stock drifted to $5, then $4, then $3, and at every step investors told themselves it would “come back.” The money tied up in Telstra was a sunk cost, exactly like the Noosa trip, but they could not bring themselves to crystallise the loss. 

More than two decades later, Telstra still trades below that T2 price. The rational question was never “will it get back to $7.40?” It was “given what I know today, is this the best use of my capital?”

Meanwhile, the same investor might have bought Afterpay at $10 and sold at $20, thrilled to have doubled their money. Afterpay went on to reach $160 before being acquired by Block. 

The gain felt good. The early sale felt prudent. But it was the disposition effect at work: grabbing the certainty of a win rather than letting a strong thesis play out.

Investors are not just making emotionally driven decisions. They are making expensive ones. The pattern has been replicated across markets globally, among both retail and professional investors. It is one of the most robust findings in all of behavioural finance.

Why this matters for momentum

Here is where it gets interesting. The disposition effect is not just a curiosity of individual behaviour. It is one of the leading explanations for why momentum works as an investment strategy.

The logic is intuitive. 

When good news arrives and a stock rises, many investors sell too early to lock in their gains. That selling pressure slows the stock's ascent toward fair value. The result is that the stock continues to drift upward over subsequent months as the information is gradually reflected in the price. 

The reverse applies to bad news: investors hold their losers, propping up the price, and the decline plays out more slowly than it should.

This creates a predictable pattern. Stocks that have been rising tend to keep rising, and stocks that have been falling tend to keep falling, in part because human loss aversion delays the adjustment to new information. 

Momentum strategies, which systematically buy recent winners and sell recent losers, profit directly from this behavioural drag.

The chart above shows the cumulative performance of a global momentum factor over three decades. 

The premium has not been smooth, and it has gone through painful drawdowns, but the long-run pattern is clear: the collective tendency of investors to sell winners too early and hold losers too long has created a persistent, exploitable return premium.

Know when to fold ‘em

Kenny Rogers had it right. The problem is that our biology makes it nearly impossible to do consistently. We anchor to sunk costs. We defer losses. We grab gains too early. And we do it even when we know better.

Awareness is a start, but it is not a solution. Even professional fund managers still exhibit the disposition effect. We are not immune. But one of the more effective defences is to take the human out of the most emotionally charged part of the process: the decision of when to sell. Rules-based frameworks and systematic disciplines do not feel the sting of a loss. They evaluate each position on its forward-looking merits, without sentiment.

That does not make the decision painless. It just ensures the pain does not get a vote.

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