In our most recent post on Loss Aversion, we reviewed how nobody likes losing and how we will go to great lengths to avoid it. Sunk Cost Fallacy relates to Loss Aversion and its impact on our decision making. To begin with, we should define sunk cost. A sunk cost is a cost that was incurred in the past and cannot be recovered. When making (rational) decisions, sunk costs should be disregarded as only current facts and potential outcomes are relevant.
An example of a sunk cost
Consider the following example to clarify the concept. Suppose we bought tickets to a baseball game this coming Friday. However, on Friday morning the weather is quite cold and uncomfortable for watching baseball (you are a fair-weather fan). At this juncture, there are two options.
- Having bought the tickets, we can go and watch the game although we know we will be cold and unhappy all afternoon.
- Having bought the tickets, we decide not to go. Instead, we spend the day indoors watching movies which we agree would be more fun.
In both cases we have already purchased the tickets and we cannot recover the money. Hence, that fact should no longer affect our choice. The decision to go to the baseball game should only depend on whether we still want to attend the game. This is because there is also an opportunity cost to attending the game. Opportunity cost is the value of the next best thing you give up whenever you make a decision. In this case, it is clearly better that we spend our time on something fun, instead of subjecting ourselves to something unpleasant merely because we purchased tickets.
However, most people will feel obliged to go to the game because people tend to focus more on what they will lose rather than what they could gain. In other words, although the costs cannot be recovered and nothing is lost by not going, people still feel as if they are losing the money they spent.
In the world of investing, sunk costs can lead people to cling to inferior options in an attempt to recoup a previous investment. When faced with a financial or investment decision, consider the optimal outcome based on current information and disregard past costs.
This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.
LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.