The sunk cost fallacy is a cognitive bias that refers to the tendency for people to continue investing resources into a project, decision, or investment even when the costs outweigh the benefits.
Essentially, the sunk cost fallacy is based on the idea that people tend to place more value on things they have already invested time, money, or effort into. Unfortunately, this way of thinking can lead to poor financial decision-making, especially when it comes to personal finances.
For example, let’s say that you’ve invested a significant amount of money in an investment that is not performing well. Rather than cutting your losses and moving on, you may continue to invest more money or refuse to sell because you feel like you have already put so much effort into it.
Another common scenario where people fall victim to the sunk cost fallacy is when they purchase items they don’t need, simply because they have already invested money into them. This can manifest in many ways, such as continuing to pay for a subscription service that you don’t use, or homeowners may continue to invest money into renovations or upgrades to their home even when it’s no longer financially viable, simply because they’ve already invested money into the property.
The Sunk Cost Fallacy isn’t limited to just financial decision making, consider a visit to the movie theater. Ever sat through a terrible movie in the theater that you already paid for, but you can’t leave since you already paid for the tickets? Staying for the entire movie makes no rational sense – the money has already been spent, and by staying you are just spending more time in an activity you aren’t enjoying. The rational answer would be to pick up and leave, but us humans don’t often behave rationally.
So, how can you avoid falling victim to the sunk cost fallacy in your financial life? Here are some strategies:
- Reframe your perspective: When making a financial decision, try to focus on the potential future benefits, rather than the costs you have already sunk. Ask yourself, “if I wasn’t already invested in this decision, would I still make it?”
- Set clear objectives and criteria: Before making any financial decisions, establish clear objectives and criteria for success. This can help you avoid making decisions based on emotions or sunk costs, and instead, focus on the metrics that matter. It always helps to write these things down and refer back to them regularly when reviewing your investment plan.
- Seek outside opinions: When making important financial decisions, it can be helpful to seek advice from objective sources, such as financial advisors or mentors. These individuals can provide valuable insights and help you make more rational decisions.
- Take a break: If you’re feeling emotionally invested in a particular financial decision, take a break to clear your head. This can help you make a more rational decision based on the facts, rather than your emotions.
A student recently summed up the sunk cost fallacy in our class this year when she exclaimed in reference to her stock portfolio, “I know I should sell, but I just can’t see myself losing all that money”. Locking in a loss, can feel like admitting that we are wrong – and losses feel worse than gains (later on that when we discuss Loss Aversion Theory). Fortunately, she was able to move forward, take the loss bravely and reinvest in new opportunities. Getting knocked down is a part of life – getting back up is what matters. Embrace the art of personal finance – numbers, emotions, culture, values and all!
Do you have any stories, advice, or comments on how the Sunk Cost Fallacy has impacted you?. We would love to hear them! Please send them to commoncents@Northbrookfinancial.com.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
Northbrook Financial is an Investment Adviser registered with the State of Maryland. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned. Please contact us at 410-941-9709 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate or modify any restrictions on the management of the account. Our current disclosure brochure, Form ADV Part 2, is available upon request, and on our website https://www.northbrookfinancial.com