Sunk Cost Fallacy - Why Smart People Hold onto Things that Donโt Serve Them and Let Go of Those That Do!
Sunk cost fallacy is the name given to the bizarre human behaviour of holding onto things that don’t serve us and letting go of the things that do.
Us humans do some pretty dim things when it comes to money and our financial well-being.
I often joke that one of the key things I learned on my road to financial freedom was how to protect my money from me.
It’s only a semi-joke because it’s true.
The study of behavioural economics is pretty much the study of trying to understand why smart people do such stupid things when it comes to money and our financial wellbeing.
There are people out there that spend their entire lives researching these bizarre phenomena, trying to understand why us - supposedly logical, smart, always looking out for our own interest humans - do so many silly things that sabotage our wealth and freedom.
The reason is simple.
We are driven by emotions.
We're driven by unconscious triggers and reactions.
It's important for us to understand this because if we think that we're making decisions consciously with our logical mind and we believe our choices are always going to be in our best interest, we're going to find ourselves pretty damn disappointed when we look back on some of our behaviours and the repercussions thereof.
Forewarned is forearmed.
When we understand (and accept) some of the economically dysfunctional natural behaviours we have, we can be forearmed, and put things in place to protect our money, protect our wealth, protect our investments, from ourselves.
This video is about one of the most disastrous economically dysfunctional behaviours we can indulge in which can sabotage our financial wellbeing and this is the fallacy of sunk cost.
So, what the hell is sunk cost, why should you be aware of it and what can you do about it?
Sunk cost is where we look at the past and consider the investment of time, money, and energy we have put into something and hold onto the thing in the hope we will get some return on it in the future even when evidence is telling us it sucks, it's dead, it’s rotten and we need to get rid of it.
The more time, money and energy we have invested in something the harder it is for us to let it go - even when it obviously isn’t good for us.
Simply put, sunk costs are payments or investments that happened in the past which can never be recovered.
The trip-wire into the seduction of the sunk cost fallacy is often the other favourite of behavioural economists - loss aversion (read this article on loss aversion and why it's also dangerous for your wealth).
Behavioural economist Dan Ariely in his book, Predictably Irrational - Writes that when factoring the costs of any exchange, you tend to focus more on what you may lose in the bargain than on what you stand to gain.
The “pain of paying,” as he puts it, arises whenever you must give up anything you own. The precise amount doesn’t matter at first. You’ll feel the pain no matter what price you must pay, and it will influence your decisions and behaviours.
Another set of behavioural economists, Hal Arkes and Catherine Blumer, created an experiment in 1985 which demonstrated our tendency to go fuzzy when sunk costs come along.
They asked subjects to assume they had spent $100 on a ticket for a ski trip in France, but soon after found a better ski trip in Switzerland for $50 and bought a ticket for this trip too. They then asked the people in the study to imagine they learned the two trips overlapped and the tickets couldn’t be refunded or resold.
Which one do you think they chose, the $100 good vacation, or the $50 great one?
Over half of the people in the study went with the more expensive trip. It may not have promised to be as fun, but the loss seemed greater.
That’s the sunk cost fallacy at work, because the money is gone no matter what. You can’t get it back.
The sunk cost fallacy prevents you from realising the best choice is to do whatever promises the better experience in the future, not that which negates the feeling of loss in the past.
Let’s look at some more examples.
Maybe you've got a business and you spent money buying the business or developing and growing it. But the reality is right now there is no market for that business, it's going backwards. At what point do you cut your losses and move forward so you can use your time, money, and your energy, to create something that is going to work for you?
A non money example of sunk cost fallacy is when we order too much food and then overeat just to “get our money's worth”.
Behavioural economics shows that people are more likely to hold on to something that they've sunk a lot of investment into even when it isn't performing well and in fact they're more likely to hold on to their poor performers than their great performers.
People are more likely to pilfer or feed off their great investments, bleed their great businesses, and fund their dodgy ones just because they've got this perception that if they get rid of the dodgy ones, only then do they lose.
This is so important to understand that whenever you're evaluating anything. Be it your investments, a business, your relationships, your habits, whether you should keep a life insurance policy… you always have to take a baseline now.
You must accept the past is history.
It doesn't matter what happened in the past, how much money and time and energy has gone into something.
The only thing that matters is what is happening - with that investment, that relationship, that habit, that eating regime, that exercise regime, that business activity - NOW and what its FUTURE potential holds?
Over and over again people tell me…
“Ann, I've been investing in this dodgy, crappy, TV dinner investment product that was sold to me by some financial advisor. I've got no idea what's in it. I can't see what the fees are. When I try and find out what it's invested in, I just get the runaround. But I've been investing in this for the last 20 years so I'm just going to hold onto it.”
Or another version..
“I know I don’t need this life insurance policy - but I’ve been paying into it for years and if I stop now I won’t get anything!”
Yes that's right - insurance is NOT an investment. Go read this article to understand what life insurance is really for and how to get (or not get) the right one for you.
This is a sunk cost fallacy doing its terrible work.
The “sunk” in the sunk cost means it's already gone.
You can't recover the past but you can make decisions now about your future and you can ask yourself…
“Does holding onto this investment or putting more money into it even when it's under-performing, going to get me to where I want to go? Or do I need to bite the bullet, accepting that the loss has already happened and liberate the money still available in the investment and get it working in a good quality asset where I can see the fees, where I can see what its performance, instead?
Use a compound calculator to help you understand the future benefit of something instead of focusing on the past or the present.
Not letting go of those things that aren't serving us, just because there's been historical investment of time, energy, money, is devastating to our wellbeing.
Do you have a business that you're holding onto that it's time for you to let it go?
Is there a relationship in your life you need to move on from?
Are there investments you need to liberate?
Is there a financial advisor you need to fire?
It's a great practice to regularly look at all the areas of our lives with a clean slate perspective.
If you were to make a choice now to invest in this thing, or spend time on that thing; or to stay in this relationship or that business; or whatever it is that you're reviewing and if there was no historical baggage, would you be making this choice?
When you look forward 5, 10, 15 years - is this choice the best for your future?
We then have to have the courage to make that clean slate choice and look to our future self and not to the lost past – because when we hold onto stuff based on sunk cost fallacy, it's going to absolutely devastate our future because…
Another aspect of sunk cost fallacy is where people hold onto physical things that are no longer serving them.
They might end up having a storage unit or the attic or the garage full of furniture and bits and pieces that they're not using.
They think, “I spent money on it, so it must have value” .
NO!!! The money is gone.
There is value only if you use something.
If you’re not using it, let it go.
Let go of the stuff that sunk cost is causing you to hold onto.
I certainly hope the insights in this article can help you let go of any sunk cost fallacies that have been holding you back and move forward with all of your resources - your time, your energy, and your money - working for you to live your greatest life possible.
Big love,
Ann
