What is the Sunk Cost Fallacy? How can it affect my finances?

How long ago did you buy those preseason NFL tickets? It’s a Wednesday night, the kids just started school a week ago, you have work first thing in the morning, and all you want to do is kick your feet up and watch some TV at home. You don’t want to get into your car, sit in traffic, pay something like 50 bucks for parking, and 10 bucks for each beer once you get inside just to see the backups go head-to-head.

But you bought those tickets months ago. You HAVE to go, or you’ll be “wasting money.”

Right?

Not so fast, according to an economic term known as the “Sunk Cost Fallacy.”

Definition

Otherwise known as “Escalation of Commitment,” the Sunk Cost Fallacy occurs when an entity or an individual continues to push forward when some sort negative outcome in a specific endeavor is looking increasingly likely.

Think of this like a pharmaceutical company. These companies can spend millions upon millions of dollars testing a drug only to realize, after years in-flight, the drug is a failure.

Instead of continuing to push forward, the company must pull the plug. The FDA will not allow the drug to go to market, so there is no use spending a penny more on its development. This in spite of the fact that millions of dollars have already been spent.

This is a very difficult decision to make, but it is the rational one. Humans tend to be extremely irrational beings. That probably explains why there are studies upon studies explaining what the Sunk Cost Fallacy is and how to push back against it.

When was the last time you bought something you didn’t need?

[Don’t miss: What is one expense you can cut this week to improve your finances?]

Probably pretty recently.

What did you do with that thing? Was it tickets to a game you really didn’t want to go to when kickoff actually came around? Maybe it was a dress with a no-return policy, or you spent $100 on a bad date.

Did you work really hard to make it work, throwing good money after bad in the hopes that things might eventually turn around?

With regards to that bad date: Maybe you asked the person you were with out for dessert. Even though you knew it was going nowhere — because you had already spent the money on dinner and you might as well just top it off with $12 worth of ice cream.

According to the sunk cost fallacy, that is “honoring” your sunk cost, and just a plain old bad idea.

When it comes to personal matters, of course, there’s such a thing as being polite. Cold, hard calculation might make sense here on a blog, but making the decision to cut off a bad date immediately might have very real and very immediate social consequences. What if it was a date set up by a mutual friend? What if she finds your Facebook profile and just savages you on it? The $12 for ice cream might be a bargain compared to that.

But you could have just politely gone home after dinner. That’s the real trick with regards understanding the sunk cost fallacy:

Know when to bail!

For the dad just hoping to relax instead of heading out the door for that preseason game, he should just stay home. Maybe he can try to resell the tickets for cheap online, but the reality is that money was spent months ago. It’s gone. Cut your losses, and just relax, or text a few friends and see if they’ll pay a little to take the tickets instead.

For the person who bought the dress with the no-return policy, it’s time to head either online or to Goodwill. Keep the closet space clear and next time shop more mindfully. Move the spent money out of your mind, as it has been spent and it is a sunk cost.

Finally, the bad date. Well, that’s a different ballgame as it involves another person. Just be polite, alright?

How does the Sunk Cost Fallacy really affect your finances?

Beyond the examples above?

Admittedly, those were one-offs. You aren’t going on a date every night, nor are you always shopping for new dresses or have the opportunity to head out to a football game.

It might be easier, in a sense, to move on from a mistake if you know that it has only happened once, and you can control whether or not it happens again.

But what about something that more commonly occurs in your life?

Entrepreneurs will continue to pour time and (at least some) money into their endeavors even if they continue to fail to gain traction. This is because they cannot let their babies go, even though at this point all of that time and cash is just plain sunk. The investors who provide capital to dozens of startups understand this, and will move on from the failure without a second thought. They understand that eventually they’ll hit it big.

And so will you. That is, as long as you work hard to keep yourself from holding on to bad investments for too long. That can mean anything at all. It could mean a house. It probably means some subscription services you don’t need anymore but still pay for every month just because you always have. Heck, it could even mean a spouse.

[Budgeting against lifestyle creep: “Same house, same spouse, same car.”]

It’s time to dig deep, and cut out what doesn’t matter

Businesses do it all the time. Think of your finances in the same way. The only way you can turn a personal “profit” is by trimming your expenditures down to the minimum.

That means understanding your wants and needs. And knowing to bail on something that isn’t providing you either profit, happiness, or both.

Even if you have been paying for it for quite some time. Especially so, in fact.

_______________________________________________________

Check out the ongoing, full retirement ladder here:

Step 0: Create a budget that helps you get wealthy

Step 1: Why building an emergency fund is so important for your nest egg

Step 1.5: What type of account is best for your emergency fund?

Step 2: Contribute to your 401(k) up to the company match

Step 2.5: How should I pick the best 401(k) investments for me?

Step 3: Pay off all high-interest debt as aggressively as possible

4 Comments

  1. Jwheeland said:

    High fee investments. Just switch those bad boys over to some low cost index funds. You don’t need a financial adviser charging 1% of assests to “manage” your portfolio. So cut your losses and move on!

    Also, humans don’t like to admit their mistakes. And the sunk cost fallacy relates directly towards that. But, think about tomorrow not yesterday.

    September 6, 2017
    Reply
    • NestEggNinja said:

      I think a major part of it is pride, absolutely. But emotional investment can play a major role here as well. It can be tough to cut bait on something we really thought was going to work. An example might be an investment we slaved over … reading the 10K, studying leadership bios, etc … only to watch it go up in flames. It can be tough to sell even after watching your principal dwindle, because you really just want it to work. Obviously, there is very little room for emotion in economics, as we well know!

      September 6, 2017
      Reply
  2. Sounds a lot like gambling, when the gambler loses all of his cash. Only that instead of walking away, he goes to the ATM, takes out more money, and tries to win back the losses.

    August 24, 2017
    Reply
    • NestEggNinja said:

      That is exactly right! The rational thing to do would be to simply cut your losses and walk away … but again, most of us simply aren’t very rational beings 🙂

      August 25, 2017
      Reply

Share your Nest Egg Ninja wisdom below!