Escalation of Commitment Can Make Things Worse
Escalation of commitment is a behavior that can sometimes make a bad situation even worse. This pattern of behavior involves the prospect of facing increasingly negative outcomes from a past investment decision. A rational investor would re-evaluate their original decision process and incorporate new information. This new information may possibly lead to the conclusion that the original investment was a mistake, and the rational action would be to liquidate, in order to eliminate possible future losses. However, for many people, there’s a reluctance to admit the past error of judgment and they escalate their commitment by investing even more money into the same declining security.
This human behavior is clearly not limited to personal finance. Military history is fraught with examples of wars that continued well past the point where it was clear that there would not be a desirable outcome. Gamblers have been known to “double-down” on a wager that has gone against them, often magnifying their losses. Many euphemisms such as “throwing good money after bad” and “if you find yourself in a hole, stop digging” have evolved over the years to help us relate this behavior to our everyday lives.
Being aware of the possibility of escalation of commitment can help us appreciate and understand the difficulties involved in active mutual fund management. A fund manager may see a recently added stock position decline in value yet continue to pour additional cash into the losing investment. The manager may claim that the continued purchases demonstrate their conviction regarding their initial analysis. In some cases, they will be proven correct as the market eventually awakens to the reality that the stock was undervalued. However, it’s also possible that the fund manager couldn’t (or wouldn’t) recognize their earlier mistake and “threw good money after bad.” Passive investing via index mutual funds and Exchange Traded Funds has become increasingly popular because it eliminates such a scenario from taking place within a particular asset category.
If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.