Do you ever feel like you're stuck in a situation because you've already invested so much time or money into it, so you think it’s just better to stick with it to the end? You're not alone. This is called the sunk cost fallacy, and it's a very common psychological trap, especially when dealing with finances.
Protect yourself – and your investments – from this irrational way of thinking. Let’s explore the meaning of the sunk-cost fallacy, why it's so easy to fall into it, and how to avoid it.
What is sunk cost?
First, we need to discuss the definition of a sunk cost. A sunk cost is a cost that has been incurred and cannot be recovered. In business, sunk costs are often used to refer to the cost of a project or venture that has already been made, regardless of whether it generates any returns.
Sunk cost is a very real occurrence that can have lasting, often negative, effects on our finances.
What is the sunk cost fallacy?
The sunk cost fallacy is a way of thinking that occurs when we believe that we have invested so much in something that we must see it through to the end, regardless of whether it is actually in our best interest.
The fallacy comes into play when we make decisions based on sunk costs. Here’s an example of a sunk cost fallacy:
You are in a long-term relationship with someone. While initially, the relationship was a healthy one, four years down the line you realize that the two of you do not share the same ideals, which has led to a lot of arguments. But because you’ve already invested so much of your time in the relationship, you find it difficult to let go, even if it is no longer healthy.
The same thing can happen with houses, cars, and other big purchases. Let’s say you purchased a new car but a few months into owning it, you realize that not only is it a gas guzzler, it is also prone to breaking down. You may think that you need to keep the car, despite all its flaws, because you spent so much to purchase it.
What you fail to take into consideration is that it will cost you even more to keep it. When it comes to sunk cost fallacy in investments, it's important to remember that we can't get that money back. Therefore, we should only be concerned with what will give us the best outcome going forward.
The sunk cost fallacy often influences us to think that we need to keep on holding on to things, even if they don’t do us any good, just because we’ve already spent time or money on them.
Thus, the sunk cost fallacy can prevent us from making the right financial decisions, because it can blind us from seeing all the relevant information. When this happens, we let sunk costs influence our decision-making instead of basing our decisions on what will give us the best outcome.
What factors lead to using the sunk cost fallacy in decision-making?
We don’t just fall into the trap of the sunk cost fallacy blindly. More often than not, they’re born from a few factors that influence our lives.
For instance, we sometimes fall into making decisions based on the sunk cost fallacy because we may feel like we must justify our previous decisions. We might think that if we've already invested so much, we have to keep going.
There are also some people who make decisions based on the sunk cost fallacy because they do not want to admit that they made a mistake. They think that because they’ve already invested a lot of money in something, they’d rather see it through to save face or because they’re hoping things will change for the better. They might justify their decision by telling themselves that they just need to keep going and it will eventually work out.
Finally, we might make the sunk cost fallacy out of being worried about the future. We might think that if we don't keep investing in something, we miss out on a good opportunity. This is when we see the importance of the time value of money, which can help you objectively identify the best opportunity for your finances.
How does the sunk cost fallacy apply in finance?
The sunk cost fallacy can be a powerful motivator when it comes to our finances. The sunk cost fallacy typically comes into play when deciding how to choose the right investment.
You hear from your friends that cryptocurrency is a good way to make money. You try out one of the play-to-earn games because your friend made a lot of money on it.
Initially, you make a good return on your investment, so you keep purchasing in-game credits so you can play more. Six months in, however, the game isn’t as lucrative as it was in the beginning, and you no longer earn as much as you used to. You’ve purchased PHP 10,000-worth of in-game credits, and you don’t want it to go to waste. So, you keep on playing in the hopes that things go back to the way they were before. You spend as much as five hours a day playing in the hopes of getting back the money you put in, even if you’ve expended so much time and effort into it to no avail.
Even though you may have read or heard that fixed-income securities and treasury bills offer more secure and steady income, the sunk-cost fallacy may push you to insist on holding on to cryptocurrency.
Do you want to make rational financial decisions?
Good money habits include extensive research and strategic thinking before making any financial decision. Understanding the sunk cost fallacy’s meaning and applications can help you make better decisions about your investments and even about life in general.
Avoid falling into the trap of the sunk cost fallacy and make better investments for yourself.