Thursday, June 28, 2007

Sunk Cost Effect

Personal Finance – “the process of planning your spending, financing, and investing so as to optimize your financial situation.” Doesn’t sound so hard does it? Much of personal finance is rational and quantifiable. Why then do so many struggle with their finances? Obviously there are a lot of potential explanations. I want to focus on one common problem – the sunk-cost effect.

The sunk cost effect is the tendency to persist in an endeavor once an investment of effort, time, or money has been made. This is problematic because it often leads to emotional rather than rational decision-making. We know [rationally] that “sunk costs” (past investments that are now irrecoverable) are irrelevant to decision making. Sunk costs are the same regardless of the course of action that we choose next. If we are to evaluate alternatives based solely on their merits, we should ignore sunk costs. We’d be better off making the decision by weighing future gains and losses. Yet, the more we invest in something (financially, emotionally, etc.) the harder it becomes for us to give up on that investment. Much research has been done in this area with interesting results. For example, one study arranged to have similar tickets for a theater performance sold at different prices; people with more expensive tickets were less likely to miss the performance. A study of NBA [basketball] players found that the higher a player was selected in the draft, the more playing time he gets [and longer career], even after adjusting for differences in performance.

Why is it so difficult to free oneself from sunk cost reasoning? We feel obligated to keep investing because, otherwise, the sunk cost will have been ‘wasted.’ We would then need to admit that we made a mistake.

Techniques for countering sunk cost bias:
1. Seek opinions from people who were uninvolved in the original choice.
2. Be alert to sunk cost bias in the decisions and recommendations made by others. “We’ve invested so much already” …
3. Don’t be afraid to admit when you are wrong.
4. Sometimes even smart choices (taking into account what was known at the time the decision was made) can have bad outcomes. Cutting your losses doesn’t necessarily mean that you were foolish to make the original choice.

A guy who knows a thing or two about money (Warren Buffet) said it well: “When you find yourself in a hole, the best thing you can do is stop digging.” So if you’re hanging on to a bad relationship or a bad financial investment, consider if your decision-making is rational or emotional … You can read more about the sunk-cost effect in the July, 2007 edition of ‘Smart Money’ magazine in the ‘7 Money Mistakes to Avoid’ (Throwing good money after bad) section.

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