Overcoming Recency Bias and the Sunk Cost Fallacy

Investing is often presented as a numbers-driven discipline, but the hardest mistakes are frequently behavioral. Two of the most common are recency bias and the sunk cost fallacy. One causes investors to give too much weight to what just happened. The other causes them to keep defending a past decision because money, time, or reputation has already been committed.

Both biases can distort judgment. Together, they can encourage investors to chase performance near the top, abandon sound strategies near the bottom, or hold losing positions long after the original thesis has broken.

Why Recent Events Feel More Important

Recency bias is the tendency to treat recent information as more important than older information, even when the older information is still relevant. After a strong market rally, investors may assume gains will continue. After a sharp decline, they may assume risk has permanently increased. The most recent price action becomes the lens through which everything else is interpreted.

This is understandable. Recent events are vivid, easy to remember, and emotionally charged. A portfolio drawdown felt last week may influence behavior more than decades of historical evidence. A stock that has doubled recently may feel safer precisely because it has already gone up, even though its valuation may now be less attractive.

How Recency Bias Distorts Risk

Recency bias often leads investors to buy high and sell low. In rising markets, confidence increases as prices rise. Investors extrapolate recent returns forward, reduce skepticism, and accept higher valuations. In falling markets, the same bias works in reverse. Recent losses feel like proof that further losses are inevitable, causing investors to sell after much of the damage has already occurred.

The bias also affects sector rotation. A popular sector may attract capital because it has recently outperformed, while neglected sectors are dismissed because they have recently lagged. This can cause portfolios to become concentrated in yesterday’s winners just as future returns become less favorable.

The Sunk Cost Fallacy

The sunk cost fallacy occurs when investors continue with a decision because of what has already been invested, rather than because the future risk-reward remains attractive. The money already lost cannot be recovered by refusing to reassess. Yet investors often hold on because selling would make the loss feel final.

This can appear in several forms. An investor may average down repeatedly without new evidence. They may keep holding a stock because they spent months researching it. They may ignore better opportunities because they want to break even first. In each case, the past is controlling a decision that should be based on the future.

When Both Biases Work Together

Recency bias and the sunk cost fallacy can reinforce each other. Consider an investor who buys a stock after a strong run. Recency bias encourages the belief that the trend will continue. If the stock later declines, the sunk cost fallacy may encourage holding because selling would confirm the mistake. The investor may then search for recent positive signals to justify staying in the position.

The result is a decision process that keeps moving the goalposts. The investor is no longer asking whether the asset offers the best risk-adjusted return today. They are trying to repair the emotional discomfort of a past decision.

Tools for Better Decisions

• Write the thesis before investing. Define why the position is attractive, what could go wrong, and what would invalidate the thesis.
• Use forward-looking questions. Ask whether you would buy the asset today at its current price if you did not already own it.
• Set review dates. Evaluate positions on a schedule rather than only during emotional market moves.
• Separate price from value. A recent decline does not automatically make an asset cheap, and a recent gain does not automatically make it strong.
• Compare opportunity costs. Capital tied to a weak thesis cannot be used elsewhere.

Building Rules That Reduce Emotional Errors

Investors can reduce bias by creating rules before emotion rises. Position limits, rebalancing bands, stop-loss policies, valuation ranges, and sell criteria all help shift decisions from impulse to process. The rules do not need to be rigid in every situation, but they provide a structure that can be reviewed calmly.

Journaling is especially useful. When investors record why they bought, what they expected, and what risks they identified, they create a record that can be tested later. This makes it harder to rewrite history after the outcome is known.

Accepting Small Mistakes to Avoid Large Ones

Many investing errors become serious because investors refuse to accept smaller mistakes early. Taking a loss can feel uncomfortable, but it may preserve capital and attention. The goal is not to avoid ever being wrong. The goal is to respond when evidence changes.

A good investor can be wrong and still make a good decision if the process was sound. A poor investor can be right temporarily and still build bad habits if the decision was driven by bias.

The Bottom Line

Recency bias makes the latest market move feel more predictive than it really is. The sunk cost fallacy makes past commitments feel more relevant than they should be. Both can push investors away from disciplined, forward-looking analysis.

Overcoming these biases requires written theses, clear sell rules, diversified information sources, and the humility to change course. Markets will always create emotional pressure. A strong process helps ensure that pressure does not become the portfolio manager.