Steven D. Levitt is a professor at the University of Chicago. He is also the holder of the John Bates Clark medal, awarded to the most influential American economist under the age of forty. He has co-written three hugely popular and thought-provoking books, yet by his own admission is more of a renegade than an acknowledged member of the establishment.
Levitt originally qualified in the respectable field of political economics, but no sooner had he done so than he packed it in. Giving up was no small thing, as he had just completed an arduous PhD programme and was well set for an academic career at a top US university. However, Levitt found the subject area crushingly boring, and so he turned his back on political economics and looked for something more interesting to do.
It was while watching a TV reality programme on working police officers that a number of intriguing questions occurred to him. Why are so many criminals and their victims drunk? How much money do drug dealers make? Does locking up a lot of criminals lower the crime rate, or just encourage new and wilder criminals to take their place?
By asking and investigating a number of unusual questions about crime and criminals, Levitt inadvertently launched a new branch of economics, one he refers to as Freakonomics. Freakonomics is actually an offshoot of behavioural economics, whose adherents think in unique and innovative ways about real-life issues. In doing so, the answers they come up with are often unexpected and counterintuitive.
Given his subsequent success, and the greater levels of enjoyment and satisfaction he derived from quitting his original career, Levitt is perplexed by the fact that humans find quitting such a hard thing to do. As he puts it: ’You’ve been at it for a while now, whatever the "it" is - a job, an academic pursuit, a business start-up, a relationship, a charitable endeavour, a military career, a sport. Maybe it’s a dream project you’ve been working on for so long you can’t even remember what got you so dreamy in the first place. In your most honest moments, it’s easy to see that things aren’t working out. So why haven’t you quit?’
Levitt’s question is one that all of us have struggled with at one time or another. The problem is that quitting goes against everything we’ve been brought up to believe in. Instead, perseverance has been sold to us as the noblest of virtues, the key to success in virtually every endeavour. ’Quitters never win and winners never quit’ says the sign at the gym. ’If at first you don’t succeed, try and try again’ is advice we attempt to live by. Giving up is admitting failure, and none of us wants to go there.
Investors have a similar problem when it comes to the disposal of losing shares. We hold onto them for way too long, even when our instincts tell us to sell. Part of the reason is that quitting is a cultural no-no, as mentioned above. But there are two other good reasons why humans have a problem with letting go, whether that relates to a relationship, a job, or holding onto a dud share. The first is...
The ’sunk cost’ fallacy
’Sunk costs’ refer to a past investment of time, money, or emotional energy into a project, person or undertaking. So, for example, you may have spent a small fortune on uncompleted studies, or invested emotionally in a project or person. In these cases, even though giving up on them might seem like a good idea, we keep going because of ’everything we’ve put into it so far.’ In terms of corporate projects this is often referred to as ’throwing good money after bad,’ but it applies equally to other investments as well.
The problem with our thinking in this regard is that we are placing great value on something that has happened in the past; something into which we have ’sunk’ a lot of time, money, energy, or all three. But why should we allow past mistakes to poison our future?
A personal example relates to my decision to study accounting at university. I drifted into this field of study by accident, and after two years knew it was not for me. But having invested two years of my life into the degree, I felt I could not possibly quit at that point. A few years later I embarked on a more advanced accounting qualification, believing that this would somehow improve my work satisfaction levels.
At the time a friend of mine queried my decision. "I thought you hated accountancy" he pointed out. When I replied in the affirmative, he smiled and said: "Remember the First Law of Holes. If you’re in one, stop digging."
It was excellent advice, which I nevertheless chose to ignore! But his words came back to haunt me over the years, and eventually I did stop digging that particular hole and climbed out. And I don’t regret it for a moment.
Nobel Prize winner Daniel Kahneman has observed that many of the decisions we face in life are ’mixed’, in that there is a chance of both loss and gain. Changing jobs, starting a business, selling a share - the examples are plentiful, and in each case we must weigh the potential benefits against the potential losses.
The trouble is, we don’t regard potential losses in the same way as potential gains. For example, Kahneman offered a number of people a bet, based on a simple heads or tails coin toss. If they guessed correctly, they would win $150. If they lost, they would have to pay him $100. Most people turned down the bet. This and other research carried out by Kahneman, confirmed that the risk of loss weighs far more heavily on people’s minds than the prospect of winning. By our nature, most of us are ’loss averse’.
Another consequence of loss aversion is that we tend to favour the status quo, i.e. we prefer to stay where we are, rather than change. It makes sense from a loss aversion perspective; right now we know what we have (zero dollars, per the betting scenario), but we don’t know what we might get (a loss of $100, for example). So we tend to see change as more risky, or more likely to produce a bad outcome. Staying put then seems to be a sensible decision, but in reality we’re being swayed by our loss-averse nature.
For investors, selling a share that is trading below the price we paid for it means accepting a loss. I don’t need to tell you why, under these circumstances, selling is so difficult! However, by maintaining the status quo we avoid a guaranteed loss, and can even imagine that the share price might rise sometime in the future. This might be far from the truth, but again we have been fooled by loss aversion.
One of the big incentives that can help us overcome our loss-averse nature is the concept of opportunity costs. An opportunity cost is defined as the benefit given up by choosing an alternative course of action. So by signing up to do a full-time MBA, for example, you lose the opportunity of working and earning a years’ worth of income. So the real cost of the MBA amounts to the tuition fees, plus the opportunity cost equal to a year’s salary.
From an investor’s point of view, by holding onto a falling share for too long, you lose the opportunity of replacing it with a better option. And in quality of life terms, the emotional cost of lost opportunities can be significant. I spent many years being miserable as an accountant, instead of quitting early and making a career change.
’You only live once’ has become the motto of the younger generation, but all of us should take its message to heart. Life is too short to waste on things we should give up on. So take a hard look at your sunk cost areas, consider the opportunity costs of not changing, and see if you can’t do some healthy quitting. The results might amaze you!
Think like a Freak, by Steven D. Levitt and Stephen J. Dubner
Thinking Fast and Slow, by Daniel Kahneman