The start of a new series! We teach you about finance, but we want to teach you some economics too so you can apply what you learn to decisions you make.
We first met David Stein on our Better Know a Millionaire series. You loved him so much we brought him back! He joins us today answer the question what is sunk cost.
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Do you know what a sunk cost is? Even if you don’t, you’ve probably fallen victim to sunk cost fallacy at some point. Today we’ll explain what sunk costs are so you can avoid them.
Abandon A Sinking Ship
A sunk cost is a past cost that you can’t recover. The sunk cost fallacy is convincing you that you can’t give up because of all the time and money you’ve already spent.
Here’s an example; you’ve spent $10,000 repairing your car over three years. That $10,000 is the sunk cost. Then the engine blows. What do you do? If you replace the engine, that’s, even more, money spent on a car that is unreliable and needs to be replaced. Good money after bad.
But if you junk the car, you’ve wasted thousands of dollars. That’s the sunk cost fallacy. What should you do? There are two answers; one is the correct one. What kind of answer you get depends on the type of economist you ask.
Old School Economists
Traditional economists theorize in a bubble. They believe that people only allow future costs, not past ones, to affect decisions. To say nothing of experience, emotion, or psychology. A traditional economist uses hard numbers to create the ideal model of what a human should consider and decide when making an economic decision. They expect that human beings will always act rationally. Ha! I don’t know what kind of human being these economists are meeting, but I’ve never met a similar one.
If you ask this kind of economist what you should do with the car, they’ll tell you to get rid of it. You lost the money; it’s over, and you have to focus on the future. The lost money should not influence your decision. The economist would tell you to sell the car and buy a new one.
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Your Caveman Brain
But human beings are not rational, and we don’t make decisions in a vacuum. We also have something known as loss aversion. Loss aversion means that people would much rather avoid a loss than acquiring a gain.
Imagine if your boss said you were going to get a $500 a week raise. You would be psyched. Now imagine that your boss said you had to take a $250 a week pay cut. People are typically more upset at the thought of that pay cut than they are excited about the pay raise, even though the amount of the cut is smaller than the amount of the raise.
Our lizard brain is not inclined to rationally evaluate sunk costs. Many people are likely to think, “I’ve put $10,000 into this car. If I walk away, I’ve wasted that money.” If you were operating in a vacuum, you would not spend any more money on this car and buy another. The money is gone and should not factor into what you do next.
Behavioral economists interject human emotion into their study of economics. They study the effects of psychology, social, and emotional factors that on economic decisions, why people make seemingly irrational decisions and why their behavior doesn’t follow the predictions made by traditional economists. They realize that we do cry over spilled milk, and it influences our decision making.
They understand why we would have a hard time walking away from that car. It’s hard to make a decision without thinking of the past and being influenced by it.
You Can’t Have Your Cake And Eat it Too
Some people confuse sunk costs with opportunity costs, but they aren’t the same. An opportunity cost is the cost incurred when you choose one thing over another.
The opportunity cost of going to college is the money you would have earned had you instead chosen to start working. Your hope is that getting a degree will allow you to get a better job than you would have gotten without the degree and that job will enable you to make up for the four years of lost wages.
The choice between two opportunity costs would be an easy one to make if you knew the outcome but of course, you can’t. After getting your degree, you might graduate into a poor job market with the added bonus of so much student loan debt that forgoing college would have been the better choice.
But now the cost of college is a sunk cost. You can’t ask for your money back. Although some people have tried. You have to move on and make the best decision going forward.
Sunk Costs and Investing
If you allow the purchase price of stock to dictate when to sell, then you’ve fallen victim to sunk cost fallacy. Investors tend to sell winning stocks too soon and hold onto losers too long.
We don’t consider a badly performing investment to be a failure until we sell it and realize the loss and that’s what drives us to sell the winners sooner and keep the losers longer.
There are two big problems with this. The momentum effect, when a stock that has been gaining is likely to continue to gain, at least in the short term, works against us when we sell that winner.
Holding onto the losers is also a bad idea because you lose out on tax loss harvesting. The loss can be used to offset tax liabilities.
Don’t Get Sunk
Knowing that a decision is a poor one isn’t always enough to stop us from making it. It’s hard to admit we’re wrong, and sometimes we will double down on a bad decision rather than admit that.
Sometimes it’s better that if at first, you don’t succeed, you give up. Acknowledge that you made a mistake and moved on. We all make mistakes, and that’s okay. It’s only a problem when you don’t learn from the mistake or when you waste time, money, and energy trying to correct a mistake that can’t be corrected.
Believe it or not, regular meditation can help you make better decisions when it comes to sunk costs. Meditating helps to develop mindfulness. Mindfulness means being in the present, free of distractions. Those distractions while you’re meditating might be noise around you, but when it comes to being mindful about financial decisions, that can mean ignoring all of the things we discussed, letting past decisions and emotion influence your next decision. That mindfulness helps us avoid the sunk cost fallacy.
It’s not easy to avoid sunk cost fallacy even when we know we’re falling into its trap. We all hate to lose money but learning to let go of the past can help us avoid losing even more in the future.
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