Some Thoughts on the Sunk Cost Fallacy

Bluejays tickets.  Photo by shareski.As you read this, my wife, my father, and I are planning on going to the Texas Rangers game tonight against the Toronto Blue Jays at Rangers Ballpark in Arlington, TX. I love going to major league baseball games and one of my smaller goals is to eventually visit every major league ballpark.

In order to get cheaper tickets, we bought the tickets in advance – they’re already paid for and printed out. We’re all ready to go to the game.

But let’s say it gets to be 6 PM this evening and our son is sick, or my dad gets tired and doesn’t feel like going.

It might make sense for me to want to push everyone to go to the ball game. After all, I already have the money invested in the tickets – we wouldn’t want that to go to waste.

In reality, though, it doesn’t actually make any sense to choose the less enjoyable option this evening if things turn out that way.

Think about it this way. I’ve already paid for the tickets – there’s no refund, no matter what we choose to do. So, in essence, all those tickets are really saying is “you have the ability to now go to the Rangers game for free this evening.”

The cost of those tickets is already sunk. It doesn’t matter what we do this evening – we’re not going to get the cost of those tickets back.

Believing that you must go to the game in order to somehow recover some value is the sunk cost fallacy – and it can be dangerous.

Here’s another example. Not too long ago, one of my readers preordered EA Sports Active for the Wii – he used Wii Fit a lot and wanted to go “beyond” it and do more cardio work. So, he paid $1 to reserve a copy at Target.

On the day of release, though, he found that he could get a free $10 gift card at Best Buy for buying a copy. He stopped at the Best Buy (next door to the Target) and picked up his copy there.

What about that $1 sunk cost at Target? Well, it was already sunk. All it did was give him a choice – pay $58.99 for the game at Target, or pay $59.99 for the game plus a $10 gift card at Best Buy. He chose the latter because the cost was sunk either way.

Here are three general ways that the sunk cost fallacy can hurt your happiness (without helping your wallet) or hurt your wallet directly.

First, it can convince you to make a poor choice about how to spend your time. In the example above, if I talked everyone into going to the Rangers game – and no one really wanted to go – under the idea that I had to somehow recover some of that sunk cost, all I’m really doing is making the evening worse for everyone. Instead, one should forget about the money entirely once you can’t recover it and make the best choice at the moment for everyone involved.

Second, it can saddle you with more debt than value. Think of people who are upside down in their car loans or upside down in their mortgage. They have already sunk money into those assets, but now the assets are still worth less than what is owed on them.

Third, it can lead you to poor investing decisions. People with investments in a dying company will often tell themselves that they can’t pull out now because they have too much invested in it – and then they lose everything. Just because you’ve invested $100,000 in something doesn’t mean it’s not the right choice to pull your investment out for $30,000 – it might be the choice to make if the investment is dying on the vine. That sunk cost doesn’t matter – what matters is getting the maximum return from where you’re sitting right now.

A few more thoughts about sunk costs and the sunk cost fallacy:

You should avoid sunk costs unless it’s highly certain that you’re going to actually do something. Most of the time, if you pay ahead for an event or an item, it’s so you can get a better deal – that’s why we bought Rangers tickets early, for example. However, if there’s a significant chance that you won’t go, you’re better off not sinking that cost in advance.

Think about it this way. There’s a good chance you’re going to go to a concert this Saturday, but you’re open to other things coming up. You can buy nonrefundable tickets in advance for $12 or at the door for $15. Which should you do? Buy at the door, of course. That way, if something comes up, you can follow the better path. Now, on the other hand, the concert might be by your favorite band ever and wild horses couldn’t keep you from going. If that’s the case, buy the tickets in advance. “I’ll do this if nothing better comes along” is not a good basis for sinking the cost.

Sometimes you can’t avoid a sunk cost – so just seek to minimize its impact. This is why you should make a large down payment on a car or home – or pay for it entirely in cash. A small down payment on a home – under 20% – makes the sunk cost worse because now you also have to sink money into mortgage insurance, for example. PMI payments are sunk costs. Similarly, if you buy a new car and don’t make a down payment, you often have to have insurance to cover that depreciation – again, an additional sunk cost. Make choices that avoid these sunk costs.

Sunk costs are often tricky. If you move into an apartment with a metro stop right outside the door and another metro stop right in front of your place of employment or school, it makes a lot of sense to sink your money into a bus pass. Now, imagine that you’re fired the next day. Suddenly, you’d like to have that $50 back.

Yet, I would still sink the cost, even with that risk. Why? Here, the bus pass has more than one use. You can ride the bus to more job interviews. You can use the bus pass to go get groceries. You can use the bus pass to visit friends.

What’s the take home message? Always make the best decision now. Don’t let yourself be swayed by money you’ve already spent and can’t get back. Instead, avoid that trap when you can.

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