“The sunk cost fallacy says that it is bad to lose something we have invested time, money, energy or emotions into, regardless of whether that something is still actually doing anything for you.” – Dr. Liz Powell.
A quick upward movement of the stock price of a struggling business when its CEO is changed is a common scenario. We wonder what goes into investors mind that they think the new CEO is their savior? What makes investors think that the new person knows exactly what the old CEO does not know? Or,more importantly, how will the new CEO fix the ongoing problem, which the old CEO could not?
If we compare any outgoing CEO and incoming CEO, by and large, they are the same. In general, most of the CEO are all MBA graduates, who are taught similar stuff and are engaged in similar businesses. In a lot of perspectives, they both have similar IQs. But, why do investors think the quite opposite? Why are investors so optimistic about this small change in management, which enables investors to gain billions of capital. Although, sometimes it becomes a short-term gain.
There is one possible answer to the investors spiked optimism.
Knowingly or unknowingly investors are a bit correct in their upswing optimism about this event. According to the business dictionary, a sunk cost is “money already spent and permanently lost. Sunk costs are past opportunity costs that are partially (as salvage, if any) or totally irretrievable and, therefore, should be considered irrelevant to future decision making.”
When the past investments made by the prior management are evaluated by the same management, the result gets infused with loads of biases. Here is what happens. Let us suppose the old CEO and his team started a special project and the project is going on for two years and is expected to complete in three years. The total cost of the project is $1 billion. At the beginning of the project, the project was deemed profitable because of the new service or product from the project. It was estimated that the project will be live in three years and generates a ton of cash in the future.
After two years, there were difficulties. In an unexpected surprise, another company was a year quick in bringing the same new service/product into the market! Now, that company has all the market share. The management knows it, but they are not willing to accept it. Let’s say, $500 million and two precious years are already spent. After knowing all this, the management is still willing to invest the remaining $500 million. Also, let engage their bright employees into this waste project rather than on a good project.
The current management acts in their own favor, not in investors favor. Accepting this project is a failure will hamper the honor of the CEO. Stakeholders may think that he/she is not quite able for the position. Worst, he/she might lose his/her job.
There is a risk of having a dent in his/her prestige. So, to save his/her back, the current CEO will come up with thousands of reason to let continue the project.
They know that this project is not a profitable venture, even though, $500 million is already spent on it. They want to spend even more money to prove something stupid.
Now, consider a new CEO has displaced the old CEO. Accepting this project as a failure will not hamper his/her prestige, and he/she will gladly do it, perhaps as soon as possible. By doing this, the investors not only save $500 million but also it can be invested in something profitable venture. This is more a psychological than analytic effect. Even a less competent CEO tha the old CEO will deliver this quick gain to investors.
- GE removed its CEO, John Flannery, and its stock went up 7.1%.
- Microsoft CEO, Steve Ballmer, resigned and its stock was up almost 9%.
There are a lot of things to consider before just letting go of the current CEO. Sunk cost is just a small portion of it and sometimes very negligible. Also, the sunk cost is a small part of investors optimism. Investors also believe that the current problems will be addressed soon. Although there is not much evidence to support this thesis.
Yes, investors save a bit through the sunk cost fallacy. However, if the problem is bigger than just sunk cost, the problem will continue. This event does not impact much in the long-term and the stock does what it is supposed to do.
By no means, one should credit the stock movement on some isolated events. Nor should we give absolute reasons to investor’s psychology. Humans are irrational and we are perfect in giving surprises. Humans created stock ticker and, now, we do not understand how it works!
Disclaimer: Long position on Microsoft.