When it comes to investing and finance, sunk costs are everywhere.
And they’re costing you money if you don’t understand about sunk cost fallacy.
To help you navigate them, Coupon Chief has created an infographic below with tips and tricks for identifying and avoiding sunk costs.
Whether you’re buying a home or an investment property, or if looking for the next great stock opportunity, it’s important to recognise sunk costs and side-step the fallacy.
Sunk Costs in Investing
For many investors, admitting to mistakes can be hard.
However, once your investment goes south, you can either change your strategy or “stick to your guns” and hope it turns around.
While changing strategies is usually the logical thing to do, many investors are tempted to ride out their losses in the hopes that the their property starts to perform better the value of the shares they’ve invested in eventually takes an upturn.
This temptation is often the result of the sunk cost fallacy, a dangerous cognitive trap that fools you into putting value into a past decision simply because you’ve already invested in it –- whether that investment is money, time, or energy.
Let’s look at a hypothetical example.
We’ll use the share market because it’s easy to understand, but obviously this relates just as much to property investments.
Imagine you buy $1,000 worth of stocks in a cloud-based startup company in January.
By December of the same year, the value has dropped to $100.
During this time, the overall market for cloud-based companies and similar stocks are rising in value.
You have two choices:
a) sell the stock for $100 and put that money into a new stock or
b) hold onto the stock in the hopes that it rises in value.
What would you do?
The sunk cost fallacy would tell you to hang onto that stock –– after all, you already invested $1,000 in it!
Unfortunately, that $1,000 is a sunk cost.
You won’t get it back now, so to make a decision based on money already spent is fruitless.
The best way to avoid the sunk cost fallacy in investment is to set intermittent goals throughout the lifetime of the investment.
For example, try setting a specific return goal for your investment portfolio over the next year.
If your portfolio fails to meet this goal, you should reevaluate it to see where you could improve or cut stocks to achieve better returns.
The Sunk Cost Fallacy in Life
The sunk cost fallacy probably sneaks up on you more often than you realise, even in the simplest of daily activities.
Here are a few scenarios you’ve probably experienced before.
Your significant other takes you on a date to an upscale restaurant in the city.
You both order and enjoy the food, but halfway through your meal, you start to feel full.
You don’t want to inconvenience your date by not finishing the food they’re paying for, so you continue to eat even though you’re stuffed.
What’s the sunk cost in this situation?
You feel the need to finish your dinner so it doesn’t go to waste, but it’s already a sunk cost for your date.
If you don’t clean the plate, your waiter is going to throw it away.
The remaining food and the money spent on the order are sunk costs.
If you’re full, you only lose by forcing yourself to continue eating.
Unfortunately, the sunk cost fallacy can even apply to your love life (or any type of relationship).
Any emotional investment in a relationship can make it harder to leave when things turn sour.
The longer you’ve been in a relationship, the harder it feels to break things off.
After all, you’ve been through so much together.
The length of time you’re in a relationship is a sunk cost.
That time can’t be recovered because it’s in the past.
However, by recognising that prior emotional investment shouldn’t be factored into your present situation, you’re already beginning to pull yourself out of the sunk cost trap.
Why Do We Fall For the Sunk Cost Fallacy?
Christopher Olivola, an assistant professor at the prestigious Carnegie Mellon’s School of Business, theorises that we feel the need to “stick to the plan” for a very specific reason.
In his paper on the topic, he cites cognitive dissonance as the main reason why people fall for the sunk cost fallacy in decisions.
When a decision-maker feels remorse around their original decision, they experience cognitive dissonance (the disconnect between an action and the emotional reaction afterwards).
This cognitive dissonance can lead some to become defensive of their original actions, leading them to continue down a path they know isn’t working.
In addition to the cognitive dissonance theory, there are other behavioural economic theories linked to the sunk cost fallacy.
These include the loss aversion bias and the status quo bias.
Read more about them below:
Loss Aversion Bias
The loss aversion bias states that the pain of losing something is twice as powerful as the pleasure of gaining an equally valuable thing.
For example, which of these would you choose:
- A guaranteed payment of $900, OR
- A 90% chance of winning $1,000 with a 10% chance of winning nothing.
In this example, most people would forego the risk and choose the guaranteed $900 payment.
Now consider this choice:
- A guaranteed loss of $900, OR
- A 90% chance of losing $1,000 with a 10% chance of losing nothing.
Now you’re probably more willing to take a risk, right?
Most people are!
In fact, most people are willing to take a risk when a loss is on the table, but not when a win is on the table.
Status Quo Bias
The status quo bias suggests that people prefer things to stay the same, either by taking no action or by sticking with a previous decision.
The kicker with this bias is that people prefer the status quo, even if it no longer serves them.
Suppose residents in two states, New Jersey and Pennsylvania, are offered two law-related insurance policies each.
The first option is more expensive, but has full rights to sue.
The second option is less expensive, but has limited rights to sue.
Which would you choose?
For the residents of New Jersey and Pennsylvania, it all came down to which option was the default.
New Jersey’s default option was the cheaper one.
Most residents chose this option.
Pennsylvania’s default option was the more expensive one.
Most residents chose this option.
Even though Pennsylvania residents’ default option was more expensive, they still chose it the majority of the time.
For most, making a change simply isn’t worth the effort, even if it’s costing them more money, time, or effort.
Avoid the sunk cost fallacy whenever possible!
Learning to sacrifice pride could result in a lot of saved money, healthier finances, and better investments.
Check out the infographic below for more on the sunk cost fallacy:
Source : Couponchief.com
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