plonkee money an english-er's thoughts on personal finance

March 27, 2009

sunk cost fallacy

Filed under: banking and economics — Tags: — plonkee @ 1:57 pm

Once you’ve irrevocably paid for something you should take that into account when considering what to do next.

Err. No.

Once the money (or time or effort) is gone, then it’s gone. There’s no point in worrying about this.

I was on a great forum the other day for people who are interested in playing classical music. In the UK, you can take exams in playing instruments, the most commonly know are the grade exams. Distinction at grade 8 is the minimum standard required for acceptance at a conservatoire (don’t need the exam, just the standard). They aren’t free to take, and there was a post on the forum from a girl stating that she didn’t want to take her Grade 7 Flute exam, but was concerned because if she didn’t the entry money her parents paid would be wasted. The right way to think of it is that whether she takes the exam or not, the money is gone. She may as well do whatever is best for her in the long run.

If you’ve spent money on something that you regret, one way to get over sunk cost fallacy is to consider what you would do now, if you were given (or won) that same object for free.

If you buy a delightful pair of shoes that turn out not to fit, instead of bemoaning the money that was spent on them, ask yourself whether you would wear them if you had been given them for free. If not, don’t wear them just because you spent money on them. If prettiness is more important to you, then by all means, ruin your feet. (I stole this example from blunt money, but it’s good! and I admit that I’ve done it myself.)

If you have an investment that you think was a mistake. Ask yourself what you would do with it if you say, inherited it now (imagine the mistake was someone else’s). Woud you keep it, or sell it?

My buying a house that has dropped in value might have been a mistake. But if I were given the house plus mortgage now, I would just keep paying out on the mortgage, rather than sell and take the loss that I can’t afford. But if I couldn’t afford the mortgage payments, it would be a different matter.

The only time you should take into account sunk costs, is when you’re learning from previous mistakes. Then it’s ok to remember that you spent a fortune on shoes that didn’t fit when you’re in the shoe shop choosing a new pair, and to take that into account by trying them out more carefully. Similarly, if your investment picking was rubbish then bear that in mind when it comes to pick new investments. Or if your house dropped in price a lot, take that possiblity more explicitly into account when you next buy (or firmly resolve never to move again, whichever).

Don’t make the mistake of considering money that’s been spent and can’t be got back when you make your decisions.

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