None of us can be the hypothetical Homo Economicus who makes only rational decisions. Instead, we must contend with the sunk cost fallacy. Here’s all you need to know about it.
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En route to becoming financially literate, one of the most important lessons to learn is that personal finance is both personal and financial. The “finance stuff,” ie the math, is relatively easy to learn. However, it must be combined with your own personal values, temperament and behavior. People don’t rack up 20% credit card debt because they can’t do math. That’s why just paying off their credit cards for them doesn’t fix the problem. Without a change in behavior, they will just build up the debt again.
Much of our financial misbehavior is due to thinking improperly. While none of us will ever be the hypothetical, Spock-like Homo Economicus, investors should be aware of some of the major behavioral finance errors. Perhaps chief among these is the sunk cost fallacy.
What Is the Sunk Cost Fallacy?
The sunk cost fallacy is the idea that money you have already spent should influence future behavior. It shows up in a dizzying array of financial situations. What all of these situations have in common, however, is that the costs are already “sunk.” They’re already gone. They should have no influence on future behavior. “The water is already under the bridge,” “the horse is already out of the barn,” and “the milk is already spilled.” Let those sunk costs go.
Sunk Cost Fallacies Examples
I’ll bet you can relate to one or more of the following examples of how the sunk cost fallacy affects our thinking, our finances, and our lives.
Waiting to Break Even Before Selling
One of the most common ways the sunk cost fallacy shows up is the unwillingness of the investor to take a loss. Imagine you bought a stock at $35 per share. It afterward drops to $25 per share. You wish you had not bought it. You would not now buy it at $25 a share. You no longer think it is a good investment. But you hold on to it because you don’t want to take the loss. You don’t want to admit you made a mistake. You want to at least get your money out of it. The worst part about this scenario, at least in a taxable account, is that you SHOULD take the loss—even if you want to keep the investment—so you can harvest tax-loss.
It shows up a lot with whole life insurance, too. “But if I just keep the policy for another seven years, I’ll break even on it.” No, your loss is already gone. It was used to pay the commission of the jerk agent who sold it to you. Let it go.
Same thing with annuities and other insurance products with surrender charges. In reality, a surrender charge is closely related to the commission. The agent/company is going to get the commission no matter what you do. It’s already spent. If you surrender the product now, they get the commission as the surrender charge. If you wait until the surrender charge goes away, they get the commission piece by piece every time you pay the life insurance policy premium or when the annual expenses are subtracted from the annuity.
This happens with rental properties and even homes. Somehow, we tie ourselves to the value we paid for it, as if that should be relevant to any future decision we make. Granted, sometimes due to excessive leverage, you literally cannot sell something because you cannot bring enough cash to the table to pay off the lender. But the price you paid for something shouldn’t affect your decision to sell it later. That’s a sunk cost.