Welcome to a week-long special about one of your greatest obstacles to financial success: your mind. Unfortunately, many of the problems that we run into with money are caused by our minds; the current financial environment is not what our minds were designed to handle. In the hopes of getting you to realize the logical flaws that plague our minds, we’re going to cover several of them this week, starting with one of the biggest, most prevalent ones:
Sunk Cost Fallacy
In a nut shell, the sunk cost fallacy is when you alter your behavior as a result of nonrecoverable money you have already spent. Unfortunately, the money you’ve spent is gone, and you can’t get those particular dollars back. You have to do what you can to maximize your future enjoyment of your money, without regards to what expenses you had in the past.
If we were completely rational beings, we would only be concerned about our future spending, not caring about what we spent in the past (at least, if there’s no possible way of getting that money back). Alas, we humans are not that logical, and we ascribe value to what we spent already, regardless of what little effect it can have on our future financial situation.
Sunk Cost Fallacy Examples
-Spending more money to fix your current car than it would take to buy a new (or at least a good used car) car, because you’ve spent money fixing the car already. (Side Note: I’ve nearly done this myself, spending more money than my car would be worth (I had bought it for $1000 several years before) to keep it running just a few more years, or more likely, months).
-Putting a nonrefundable down payment on an item at one store, before finding it somewhere else for lower cost (lower than the retail price minus the down payment). If you opt for the less expensive item (which is the most economically sensible decision), then your down payment will be lost, an expense beyond the cost of the item.
-Holding a declining investment, while waiting for it to ‘break even’. There are no guarantees in investing, and there’s no reason to think that your investment will necessarily come back, particularly to the fairly arbitrary point set when you bought it. Investments don’t know how much you spent on them; good ones will increase in value and poor ones will decline, regardless of how much you spent to purchase them.
Beating the Sunk Cost Fallacy
The problem with the sunk cost fallacy is ascribing your past spending with equal weight to your future spending. The best way to avoid falling into this trap is to re-evaluate your future spending while ignoring the money you’ve spent previously. Ask yourself, ‘If I was making this purchase today, with no knowledge of what I’ve spent in the past, would I still make it?’ If it’s not worthwhile to make the purchase fresh, it’s not worth spending more money on it; chock up any down payments or previous expenses as the cost of doing business.
This argument applies with investing costs. The cost of buying your investments can be considered sunk; if the investment declines, you have no way of getting your investment back. You need to evaluate your investments on the basis of where they stand currently and where they will go in the future. If the investment is declining, particularly if it is an investment like individual stocks that can go to zero, you need to ask yourself if you genuinely believe the investment will rise in the future. Evaluate your investments as if you are putting in new money today, even if you aren’t, so you aren’t considering costs that are already sunk in your decisions.
As with any logical problem, it’s easy to fall into the sunk cost fallacy; our minds are designed to work in ways that aren’t conducive to our long term financial future. You’re going to need to make some effort to avoid it. Remember that money that’s been spent cannot be recovered in many cases, and as a result, shouldn’t factor into your future financial decisions. While you shouldn’t forget the past, you should be sure to keep it in perspective, and not allow your past decisions to dictate future, less than ideal actions.