Question

Earnest B, Bass, a financial advisor, recently told one of his clients: "The biggest mistake you can make is to hold onto a stock for too long in order to avoid a loss. Let's say you bought a stock for $50 per share but that six months later the price fell to $40 after a poor earnings report. Many of my clients in this situation will hold the stock, hoping the price will later rise above $50. In most cases like this the price does not rise and may even fall. You must know when to cut your losses." Which of the following is the best explanation for Earnest B. Bass's advice?

A) People sometimes buy stocks because other people are buying them or they want to appear to be fashionable.

B) People sometimes make mistakes when they buy stocks because of the endowment effect.

C) People sometimes make mistakes when they buy stocks or when they buy goods and services: they ignore the monetary opportunity costs of their choices.

D) People often fail to ignore the sunk costs of their decisions. The cost of the stock bought at $50 per share is a sunk cost.

Answer 1

The financial advisor has stated that people tends to increase their loss by holding the stock even though the price of stock is falling and chances of its rebound are next to zero.

In such scenario, stock holder is not considering the economic term sunk cost.

This term states that there are some costs that once incurred cannot be recovered.

Similarly, with respect to a stock, if its value has decreased then investor should consider its purchase value as sunk cost. If a investor does this then he or she knows that purchase price cannot be recovered.

In such case, he or she will sell the stock the earliest to salvage what can be.

Thus,

The correct answer is the option (D) {People often fail to ignore the sunk costs of their decisions. The cost of the stock bought at $50 per share is a sunk cost}.