Sunk Costs In Investing

Sunk costs in investing are very close to the phenomenon knows as ?anchoring.?

If you buy a stock at $10 ? and it sinks to $5you are faced with 3 choices:

1. buy more at a lower price ? average down

2. sell your loser

3. do nothing and hope it rises phoenix like back to your cost basis.

All of these decisions will be made with sunk costs and anchoring involved. If you buy more you may think that you should get back to your cost basis ? and the fact that you already have an investment at $10 will fixate you on that level. You will think ?I can double my money on the new investment and break even on the original? You are dealing with the sunk cost ? and you have anchored yourself to the $10 price tag.

Similarly, if you decide to do nothing ? you may just be waiting for the company to get back to where you started. You are anchored at the original price.

Only the sale at a sure loss is a decision where you have weighed the sunk cost ? thrown off the anchor and moved on.

In hedge funds and personal accounts ? this is a somewhat easier decision to make ? because you can recycle the capital easily and move on.

In venture firms, it is much harder for a number of reasons.

Firstly, venture investors mark their books ? usually at the last round of financing ? so down rounds are a no ? no. It makes it seem like the company is not doing well ? and makes it harder potentially to raise the next fund.

Secondly, venture investments are illiquid, so simply calling a bad investment a sunk cost is more akin to calling it a permanent loss of capital. If it is a small company and not going in the right direction ? it is very hard to get anything back.

Thirdly, there is the reputation or signaling issue to deal with. If you abandon the investment as a VC ? what signal does it send to potential other investors? What does it do to your reputation with potential partners in the future?

Finally, and I think this is the biggest one ? since venture funds do not recycle capital ? any investment ? no matter how bad it is going, always has an option value. Think of it as a lottery ticket. It doesn?t happen often, but if a company successfully pivots and becomes a winner ? you want to hold onto the lottery ticket. In the public markets ? you can sell back your lottery ticket. In venture, you buy it, you keep it. So why give it up?

Of course this last point leads to a highly skewed return profile for venture investments ? generally, they are either home runs or strike outs ? with very little in the middle. Public markets are exactly the opposite ? because there is neither institutional anchoring nor a sunk cost problem in the public markets ? but these are structurally built into the VC model.

Source: http://www.horsesaysinternet.com/venture-capital/sunk-costs-in-investing/

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