Success in the area of personal finance is much more about behavior and habits than it is about math or head knowledge. Sometimes the behavioral aspects are pretty obvious, like using a budget, living on less than you make, and getting out of debt. But sometimes the underlying psychological factors that affect our behavior with money are a bit more subtle.
One such factor that has a dramatic effect on our big dollar money decisions deserves some exposure. It’s called the “Sunk Cost Fallacy”.
A “sunk cost” is any past cost or investment, of time or of money, that cannot be recovered. Regardless of the outcome at this point, and regardless of what you do in the future, that cost has been paid and will not be recouped.
We fall prey to the sunk cost fallacy when we are so emotionally attached to the time or money we have lost, that we allow ourselves to continue down the wrong path or make a bad decision about the future, based on that loss. We try to justify continued investment or commitment by saying that otherwise our previous investment will be “wasted”.
There are countless examples of the sunk cost fallacy in everyday life:
Finishing an expensive restaurant meal that you don’t like, or continuing to eat after you are stuffed.
Going to an event that you paid for and can’t get a refund for, when you have either changed your mind about going, or perhaps are so sick that you couldn’t possibly enjoy it.
Continuing to date someone you realize is never going to be marriage material, just because so much time has passed.
In my own life (and many others as well, I’m sure) it was continuing for far too long in a career that I was ill-suited for and did not enjoy, because I had invested 10 years of college and grad school in getting degrees in that field.
We can imagine examples where the futility of continuing a commitment is so obvious that we would never commit the sunk cost fallacy. Say you dropped your cell phone into the ocean off of a ship. Theoretically you might be able to recover it, if you spent a fortune on technology, equipment and personnel to locate and retrieve it. But you would never do that!
The cliché you are familiar with is this: “Don’t throw good money after bad.”
Or maybe you bought several gallons of expensive custom color paint for your house. After using about half of the first gallon, you realize the color is actually atrocious and you couldn’t possibly live with that color. You wouldn’t continue painting your entire house, just because you can’t return the paint to the store.
But the fallacy is not always that obvious. And the more money is involved, the easier it is to fall into the trap.
In the business world, it might take the form of a business owner who pays a consultant big bucks to determine whether to enter a particular market. The analysis says that, no, it would be a bad idea, due to the idea’s reliance on technology that is becoming obsolete. The business owner proceeds anyway, because they already spent the money on the analysis. The business, quite predictably, fails.
In the personal finance realm, the sunk cost fallacy might result in one of these scenarios:
A military family buys a house in the town where they are stationed. In 3 years or so, they are relocated to their next assignment. They keep the house and try to rent it out, rather than selling it, and over the years collect rental houses dotted all over the country which they can’t properly manage.
A homeowner bought their house at the top of the market (like back in 2008) and its value has dropped, such that their mortgage balance is higher than the current value of the home. They want to sell and move, but their asking price is too high because they want to get enough to pay off the loan. The home doesn’t sell, the family moves, and the home sits vacant while the family pays two mortgage payments month after month.
So how do you avoid making bad decisions due to the sunk cost fallacy?
1. First and foremost, be aware that this fallacy exists, and examine how it may manifest itself in the decision you are facing.
2. Be willing to admit your past mistakes. You’ll never make better decisions if you can’t acknowledge the problems with your previous ones.
3. Get a clear vision of what you want your future to look like, and make your decisions based only on that.
4. Ask yourself this question: “If this situation did not already exist, would I purposely create it?”
That last question is extremely useful. Here are some examples of what that might look like:
You own a piece of rental property. It has enough equity in it that you could pay off your home mortgage if you sold the property. So ask yourself: “If I had that much money in my pocket, and I didn’t own any rental property, would I use that money to buy this rental, or to pay off my home?” In other words, would you buy that rental again today, if you didn’t already own it? If not, then you should sell it, and use the money for something else, like paying off your own home.
You have about $100,000 in non-retirement mutual funds. You also owe $100,000 on your home mortgage. The question here is “If you owned your home free and clear, but had no investments, would you borrow $100,000 against your home and use the money to invest?” If your answer is no, as it is for most rational people, then you should sell the investments and use the money to pay off your home. Asking it that way forces you to factor in the risk of the investments like you hadn’t done before. (The risk being that the investment’s value could tank, while the mortgage debt will never just disappear.)
A common one I hear goes something like this: “I know I have $20,000 in my emergency fund, and $19,000 in credit card debt, but I get a feeling of security from having that money in the bank”. So the question is: "If you were debt free, but also had only $1000 in your emergency fund, would you go take out a loan in order to put the money into your emergency fund?" Gasp!!! NO, of course not, is the answer, every time. Nobody does that, because they would, rightly, see it as foolish. Take the money out of your emergency fund and pay off your debt.
If you’re facing a big dollar decision and would like help talking through your scenario in light of the sunk cost fallacy, I’d be happy to discuss it with you. You can find me at www.moneycoachbev.com, or just call me at 724-448-6730.