The Yankees' A Rod Problem: Sunk costs and investing

As any baseball fan knows, the New York Yankees have an A Rod problem. Just in case you have no idea what I am talking about, A Rod is Alex Rodriguez, the third baseman for the New York Yankees, signed in December 2007 to a one of the richest sports contracts in history. The Yankees, dazzled by the the numbers that A Rod posted in 2007 and by the possibility that he could become baseball's home run king (with 500 home runs, he seemed to be on a path to beating Barry Bond's record of 762 home runs), signed the then 33-year old to a ten-year contract worth $275 million (with numerous bonus clauses for breaking home run records). The five years since have not measured up to expectations, with the disappointment building to a crescendo in the 2012 post-season, when A Rod's anemic hitting led to his being benched in the last two games against the Detroit Tigers. Now, the Yankees owe $114 million over the next 5 years to a 38-year old third baseman, who is susceptible to injuries and has seem to have lost his home run power  and his capacity to hit right handed pitching.  

What should the Yankees do with A Rod? If they follow financial first principles, the contractual commitment of $114 million that they have already entered into should not be part of the calculus in any decision that they make now. Thus, if they feel that A Rod, based upon his current skill level (and age), is worth only $3 million a year for the next 5 years, they should be willing to consider trading him to another team (assuming he okays the trade) that will offer even a little bit more (say $3.1 million/year) in return, and eat the rest of the contract (about hundred million). Will they do it? I don't think so, because any such deal be an explicit admission that they made a horrendous mistake five years ago. Instead, what you are most likely to see is A Rod at third base for the Yankees, to start the next season, with everyone hoping and praying that he discovered the fountain of youth (at least a legal version of it) in the off season.

The financial principle I was referencing is of course the one of sunk costs and anyone who has taken a basic corporate finance class knows the rule. A cost that you have already incurred or are contractually committed to incur should be ignored in your decision making. That rule, though, is easier enunciated than put into practice and here is a simple exercise to see why:

1A. Assume that you are the manager of a business that is in ongoing development of a new product that will require spending an additional $100 million to bring to completion. Assume that you have just learned that a competitor has come up with a superior product at a lower cost and will be bring it to 

the market at the same time as you will. Would you spend the $100 million?

a) Yes

b) No

1B. Now assume that the same facts as in the prior case but also assume that you know that you have already spent $ 900 million on developing this product. Would you spend the additional $100 million?
a) Yes
b) No

For most of you, I am sure that the answer would have been an easy "No" for 1A, since spending an extra $ 100 million on a product that will not compete seems pointless. For some of you, though, was it more difficult to say "No" to 1B? If so, you are not alone since 80% of managers in an experiment that asked exactly these questions were swayed by the sunk costs into investing in a doomed project. Interestingly, there have also been follow up studies that find that if decision makers were responsible for incurring the sunk costs in the first place, they are even more likely to be swayed by those costs.  In behavioral finance, the capacity of sunk costs to affect decisions falls under what is termed the "Concorde fallacy", named after the ill-fated supersonic jet that the British and French governments poured billions of dollars into, even in the face of clear evidence that it would never be a commercial success, partly because they had already spent so many billions in development.

If you are an investor, you may wonder what this post has to do with you. I think we are all susceptible to the sunk cost problem. To illustrate, let's try a different experiment:
2A. Assume that you are looking at a stock trading at $10/share and that you have valued the shares at $8/share. Would you buy the stock?
a) Yes
b) No

2B. Now assume that you are looking at the same stock trading at $10/share, but that it already part of your portfolio and you bought it at $50/share. If your value per share is $8, would you continue to hold the stock?
a) Yes
b) No

2C.  Now assume that you are looking at the same stock trading at $10/share, but that it already part of your portfolio and you bought it at $2/share. If your value per share is $8, would you continue to hold the stock?
a) Yes
b) No

I am sure that the answer that you gave to question 2A was an unequivocal "No" but was your answer different for 2B? And how about 2C?  (Remember that holding a stock in your portfolio is equivalent to buying the stock....) If the answers were different, why? After all, on an incremental basis, the choice is exactly the same, and an investor who would not buy the stock in 2A would have also sold the stock in 2B and 2C.

The problem is that investors seem to have different sets of rules, one for new or marginal investments, and one for existing investments. Rationally, your decision on whether to keep an investment in your portfolio should be based on whether that investment is cheap or expensive, given its price and value today, and not on what you originally paid for the investment or its value then.  (I know that taxes can create a real issue here, but this problem seems to persist even for tax exempt investors.) However, we are human and almost by definition, we are not rational, and behavioral finance chronicles the costs that we bear. In particular, there is significant evidence that investors sell winners too early and hold on to losing stocks much too long, using a mixture of rationalization and denial to to justify doing so.  Shefrin and Statman coined this the "disposition effect" and  Terrence O'Dean looked at the trading records of 10,000 investors in the 1980s to conclude that this irrationality cost them, on average, about 4.4% in annual returns. Behavioral economists attribute the disposition effect to a variety of factors including over confidence (that your original analysis was right and the market is wrong), mental accounting (a paper loss is less painful than a realized loss) and lack of self control (where you abandon rules that you set for yourself).

So, is there anything that we can do to minimize the disposition effect? I don't have the answer but here are some things that you could consider. I employ the first two in my portfolio and while I cannot quantify how much they have saved me, they have brought me peace of mind.

1. Regular value audits: The easiest path to the disposition effect is denial, where we refuse to look at the investments that we already have in our portfolio because we are afraid of what we may find. In fact, think about how much time we spend trying to come up with new investments to add to our portfolios (it is always more fun to start anew) and how little time we spend on maintenance investing. One practice that I have instituted for myself is that I have to value every company that is already in my portfolio at least once a year. It forces to me to take a look at the company, as if it were a new investment, and decide whether it deserves to stay in my portfolio another year. Since I have about 40 stocks in my portfolio, it does require some discipline but I think it has been well worth the cost.
2. A selling rationale: Even with these value audits, I (like most investors) find it difficult to let go of losers, since selling a stock that has gone down is an explicit admission that I made a mistake. So, I provide myself with cover, especially at year end. For every winner that I sell each year (and I do sell one or two that have become over valued, at least in my judgment), I look for a loser (which is also over valued, in my judgment) that I will unload to reduce my tax exposure. Thus, rather than having to admit that I made a mistake, I can pat myself on the back for a savvy tax trade. Delusional, I know, but it helps...
3. Automated rules: If the first two suggestions don't work, there is a third option, which is to take control of the decision out of your hands. You can put in a stop loss order, specifying that a stock that drops more than X% from your original purchase price, it gets sold automatically. It is a bludgeon, because that stock may very have become a bargain, but you may be saving yourself some bad disposition effect losses.
4. Decision making separation: If it is the unwillingness to admit to your own mistakes that lies at the heart of the "disposition effect", it may be alleviated (at least in part) if the person making the assessment of whether to hold or sell a losing stock is not the person who made the mistake of buying the stock in the first place. Perhaps, mutual fund managers should work in pairs, with one manager responsible for making new investment picks and the other in charge of monitoring existing investments. Impossible to do for individuals, you might say... but I am considering talking to my wife about splitting the investment management role in our family. She can be the stock picker and I could be the stock assessor or vice versa.... One of us gets to make judgments on the other's mistakes.. On second thoughts, scratch that idea..

So, as we watch the Yankees tackle their A Rod problem, it is worth remembering that we all have our own versions of the same problem: a reluctance to admit to our past "investing" mistakes and let sunk costs be sunk costs.