When should investors cut off their arms?

Imagine you're hanging 20 metres above the ground, your arm wedged between rocks on a cliff face. After seven days, your situation worsening with every daybreak, what do you think you would do?

Aron Ralston took matters into his own hands. With his water running out and no sign of help, he hacked off his arm with a knife and abseiled down the cliff face to safety.

That's just one reason why I prefer investing to mountaineering, although Ralston's story is especially pertinent for Slater & Gordon (ASX:SGH) shareholders currently sitting on a 96% loss over the past year.

This time last year the company's shares were trading for $7.15. Yesterday, they closed at 27 cents. Slater & Gordon's stock would need to rise 27-fold to recover from a loss like that. That's what the scientists might call a low probability event.

And yet there the shareholders hang, like Aron Ralston before he pulled out his knife, facing the worst possible outcome but not yet having found the courage to act. Even at 27 cents, some shareholders can't cut themselves loose even though the company's continued existence is at stake.

Too often investors sit on capital losses rather than cutting them. Instead of preserving what little capital might be left, we hang on, hoping for a miracle, which in this case would see Slater & Gordon's share price rise so improbably it beggars belief.

Economists call it the sunk cost fallacy. The rest of us should call it what it is – irrational thinking that usually increases the financial damage of an already dire situation.

You may recognise the sunk cost fallacy in that friend who hangs on in a bad relationship because they've already invested a few years in making it work. Or in the diners at a restaurant that insist on finishing everything on their plate because they've paid for it, even though they're no longer hungry.

With little chance of recovery and the very real possibility of the stock going to zero, the rational thing to do is to accept your losses and sell out. But the sunk cost fallacy stops us from doing so. We hang on, usually making a bad situation even worse.

Of course, there will be times where your losses are so severe that you will feel that it isn't worth selling. For some, Slater & Gordon right now might be one such example.

Those hoping for a rebound before finally selling out are usually making a mistake for two reasons. First, there's no guarantee the company will pull out of its nose dive. Second, even if it did, why do you need to make the money back the same way you lost it?

Instead of sitting and hoping, you could get out and use that money to invest in more attractive opportunities. That's the rational course of action, one that many investors choose not to take.

Ralston made the right choice. He ignored the time spent trapped, hoping against hope that things would get better and is climbing mountains today because he didn't fall for the sunk cost fallacy.

No one likes to lose money. Recognising that fact by selling for a 96% loss is so painful that many investors chose not to do it at all. And yet whilst getting out and moving on may hurt your pride and ego, in all likelihood it will also lower your stress levels and increase your bank balance.

Selling Slater & Gordon at 27 cents isn't easy but it's almost certainly the rational, sensible thing to do, painful as it might be.

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