Money Traps, Part 3: The Sunk Cost Fallacy

by Jessica Sommerfield · 3 comments

Have you ever sat through a bad movie just because you didn’t want to “waste” the money you spent on the ticket? What about a dud of a car that you refused to give up on despite multiple trips to the mechanic? If so, you’re not alone. This behavior is a mental money trap economists and psychologists call the sunk cost fallacy or the escalation of commitment, and it can cost us money, time and unnecessary emotional stress.

Why do we so often stubbornly refuse to count our losses and move on? Let’s expound a little on what the sunk cost fallacy looks like.

Most of us have an instinctual aversion to loss. In many situations, the prospect of losing money becomes more powerful than any other reasoning — even the possibility of coming out ahead. This is easily illustrated by gambling habits. Based on behavioral studies, most people refuse to bet on anything if the promised payoff is less than double their investment.

On the flip side, this might also be why we have an affinity for free deals or gimmicks. We’re more than willing to take something that’s free, even if it’s not anything we need or even like.

Secondly, the more we invest in something, the harder it is to take what we believe to be a loss on it. It’s strange to think that we can get emotionally attached to objects, but it’s true. Investing money into something comes to signify more to us than just cash – it’s our time and our labor.

Sitting through a movie you don’t like just because you paid for it is a light-hearted example, but this fallacy hits harder when it affects larger things like stocks or real estate. Some people find it hard to part with a poorly-performing investment, waiting and foolishly holding out for the stock to perform better when all the signs say to sell it and reinvest somewhere else.

Trying to get the maximum return on any investment is wise, but propping up a “sinking ship” isn’t.

David’s Note: I’m right smack middle of letting emotions drive investment decisions. I’ve been selling some of my legacy individual stock holdings to be more fully invested in index funds and I notice that I tend to more freely sell ones that have done better while not wanting to sell any that hasn’t performed well. Will I hold onto those stocks forever? Will I get lucky that they get a pop in price? Who really knows but I certainly hope I can overcome my emotions and let them go because the long term potential for those securities just isn’t there.

Others might have a hard time selling their home for less than they paid for it years ago, even if they can fetch a solid price based on today’s market prices. Unless you have fact-based reasons to believe the housing market will improve, holding out to sell could mean getting even less than your home’s value if, instead, the market takes a dive.

To combat the sunk cost fallacy, keep the following things in mind.

1. Remember that, in many cases, money spent in the past no longer factors into making the wisest financial decision in the present.

Would you still buy that stock today, with its current performance?

Without factoring in what you paid or the money you sunk into it, would you feel like you were getting a good deal if you bought your home today, at its market value?

What is your car’s current value, today, regardless of what you bought the vehicle for? If someone had given it to you for free, would you still poor money into the ride?

2. Use the concept of a stop-loss order to cut emotions out of your decisions.

In the stock market world, a stop-loss order sets the price at which a broker is supposed to sell a holding if the market takes a turn for the worse (there’s much more to it, but that’s the overall idea). It’s a proactive way to avoid losses with less active management of your stocks, but you can apply the concept to anything you invest money in. Set a limit at which you’ll stop pouring money into a lost cause – be it a stock, a car, or something else. This will help you make decisions based more on numbers versus feelings.

David’s Note: Be careful with setting automatic stop loss orders on stocks within your stock broker platform. Since stock values are volatile, you can get stopped out, realize the stocks you own were all sold and see that the price has already bounced back if you don’t know what you are doing. It’s good to have a mental stop loss for any investment, but you really ned to know what’s going on to use the automated trading tools every broker seems to have now.

Don’t let the sunk cost fallacy mindset get the best of you. Asking these questions can help you get past the hang-up of “lost” money that’s in the past and keep you from hesitating to make the best financial decisions for today.

Like this article? Check out the other parts of the money trap series below:

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  • Jordan says:

    Back in my undergrad, we had a great program where finance students managed a portion of the University’s endowment. The professor that managed the program really instilled in us to avoid the sunk cost fallacy. Always used the example that if a stock loses 25% of it’s value (apart from a total market downtrend of course) that you might think it needs to make a 25% return to get your money back but in reality you need to make 50% return to get back to even. You have to sell the losers and find a winner and you covered this well in not only stocks but in most parts of our lives.

  • Do you think this applies to our career paths as well? I think it is difficult for some people to realize that they have put a lot of time into a career that isn’t going to pay off in the way they thought it was. If you are someone working in a dying industry when do you “cut your losses” and look to build again?

  • Steve from Arkansas says:

    I love seeing sunk costs discussed. One irony is that there are times when sunk cost is a valid reason to spend more time, money, etc. I have two friends that were less than a full semester away from engineering degrees. They walked away to pursue other careers but I would call it a dumb move. At that point your future is unknown and you can’t possibly assign a zero value to an engineering degree, and the incremental cost is tiny. The only smart move is to spend a tiny sum and have a degree vs having spent a lot for nothing. The whole cost of the degree probably was a big waste but the tiny cost to finish it, worth the tiny gamble.

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