One psychological trap that investors can fall into is escalation of commitment, an investment bias where individuals continue to invest time, money or resources into a failing decision, strategy or investment, often to their detriment. This article will explore the concept of escalation of commitment, provide historical examples of its occurrence and suggest techniques to avoid this pitfall in investment decisions.
UNDERSTANDING ESCALATION OF COMMITMENT IN INVESTING
Escalation of commitment refers to the decision-making bias where investors become overly committed or 'locked in' to a particular course of action, even in the face of clear evidence that it is failing. This often occurs because admitting failure would mean confronting the possibility that previous investments were a mistake. In the investment world, this can manifest as continually investing in a declining stock, doubling down on a losing strategy or refusing to divest from an unprofitable venture.
The root of escalation of commitment lies in a mix of cognitive dissonance, loss aversion and the desire to avoid admitting error. These psychological factors can cloud judgment, leading investors to throw good money after bad in the hope of turning a situation around or at least breaking even.
HISTORICAL INSTANCES OF ESCALATION OF COMMITMENT
The Bear Stearns collapse (2008): In the lead-up to the 2008 financial crisis, Bear Stearns, a global investment bank, escalated its commitment to mortgage-backed securities, despite signs of a housing market collapse. This resulted in significant losses and ultimately contributed to the firm's demise.
The British government on Black Wednesday (1992): The British government's decision to keep the pound in the European Exchange Rate Mechanism despite market pressures is another example. Despite spending billions in reserves to prop up the pound, the government eventually had to withdraw from the mechanism, leading to substantial financial losses.
TECHNIQUES TO AVOID ESCALATING COMMITMENT
Set predefined exit points: Establish clear criteria for when to cut losses on an investment. This can involve setting stop-loss orders or defining specific performance benchmarks.
Regular portfolio reviews: Conducting regular reviews of investment strategies and portfolio performance can help identify underperforming assets and prevent emotional attachment to specific investments.
Seek external opinions: Consulting with financial advisers or analysts can provide an objective perspective, helping to counter personal biases.
Embrace a learning mindset: Viewing investment mistakes as learning opportunities can help mitigate the psychological need to 'prove oneself right', reducing the likelihood of escalating commitment.
Diversification: A well-diversified portfolio can reduce the emotional burden of individual investment performance, lessening the temptation to double down on failing investments.
Escalation of commitment in investment decisions can lead to significant financial losses and missed opportunities. Recognising and actively working to counter this bias is crucial for effective investment management. By setting predefined exit strategies, conducting regular reviews, seeking external advice, adopting a learning mindset and ensuring diversification, investors can make more rational and less emotionally-driven decisions.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.