Logic can be really complicated. Common sense may get you through the day in one piece, but when you’re dealing with finances, what you really want is good sense. The problem is that human brains have a tendency to try and find patterns in the world around them.
While this pattern-seeking behavior is necessary for people to function (you assume that you won’t fall into oblivion with every step you take based on the pattern that the ground stopped you from falling before), sometimes it can lead people to make incorrect conclusions. When you rely on faulty logic, you’re relying on a fallacy.
Logical fallacies can be based on flawed logic structure, distractions, emotional response, or any number of other factors that use information not related to the decision at hand. In finance, a fallacy can lead to a huge mistake resulting from improper judgment.
For example, you may think that a company is a bad investment because the owner is a 20-year-old college drop-out, but if every investor had given in to that fallacy, no one would’ve invested in a new company called Microsoft. Fortunately for Microsoft, their investors relied on logical decisions in which they utilized data in a proper manner, without letting outside sources and unrelated information interfere.
Here are two common fallacies that you may come across in your corporate finance career:
Gambler’s Fallacy: This fallacy involves irrationally measuring the probability of an outcome. Pretend that you bought one share of stock and that stock is doing awful. Instead of selling that stock and investing in something else, you hold onto it because you keep thinking that it has to go up eventually, that statistically it can’t go down every single day.
That’s faulty thinking. Even assuming equal probability of increase or decrease in value — that each new day brings a 50 percent chance that the company’s stock will increase — isn’t accurate because a poorly performing company has a greater probability of decreasing in value.
Sunk Cost Fallacy (or “money pit”): This fallacy refers to the idea that a company (or individual) has already put so much money or effort into a project that it has to continue to pursue it at any additional cost. The fallacy is in value assessment and tends to be very emotionally charged.
In investing, it’s called the disposition effect, which is when investors are more willing to accept gains than losses and end up holding bad stock because they think the price will come back up to the original purchase price eventually.
To see this fallacy in action, imagine that you’re an entrepreneur and you start a company that makes car horns that sound like ducks. The company does terribly, so you continue to dump money into advertising to try to get sales up.
Because you put so much money into the start-up costs (now considered sunk costs because they can’t be recovered), you refuse to accept that investing in this company was a bad idea. Even though the original costs may be sunk already, continuing to put money into the bad company is just making things worse for you.