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.

Open Courseware

Nearly two years ago at a financial counseling conference, I learned about a newly established consortium of Universities around the world that had collaborated to provide free, open access to educational materials. It sounded like an interesting idea at the time; I hadn’t heard anything about it since until this past week when I was reading the most recent edition of Kiplinger’s Magazine. The article – “Audit a course for free at Online U” shares a little more about this consortium that is a literal ‘who’s who’ of Universities – Johns Hopkins, Notre Dame, Tufts, Michigan State, Harvard Law, and MIT (the pioneer of this ‘open courseware’ movement) who will have at least some teaching materials from all 1,800 of their undergraduate and graduate courses this fall. While access to the materials is free, you won’t get credit toward a degree or have the ability to interact with other students or a professor.

I was able to find a couple of the courses that were personal finance-related. One is offered through UC-Irvine and appears to offer some valuable information related to ‘Fundamentals of Financial Planning;' Utah State also shares information about their undergraduate Family Finance class. The general content available from each course will vary dramatically – some have little more than a syllabus/ reading list. Others provide full PowerPoint slides for lectures, audio podcasts, video webcasts, exams … the whole nine yards. The link below to the list of consortium members will allow you to visit Universities that provide resources associated with a myriad of course topics.

The current consortium consists of more than 100 institutions of higher education. Additional information is available at http://www.ocwconsortium.org/about/index.shtml.

Sampling of other free online Personal Finance courses:
- Consumer Debit Resource – ‘Checkbook Basics’
- FDIC – ‘Money Smart’
- Florida State – ‘Fundamentals of Financial Planning’
- Freddie Mac – ‘Credit Smart’
- IRS – ‘Understanding Taxes’
- Money 4 Living
- Money SKILL
- NEFE – ‘High School Financial Planning Program’
- Rhode Island Center for Personal Financial Education – ‘Credit 101’
- Rutgers – ‘Investing for your Future’
- Smart Money – ‘Investing 101’
- Spend 2 Success
- Visa – ‘Practical Money Skills for Life’

This list should not be considered exhaustive by any means nor expected to represent an endorsement of any curriculum or program. The resources are merely informational. If you are aware of other good resources, please share them with me.