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Financial Advice: Avoiding The Sunk Cost Fallacy

Posted: 12/05/11 03:37 PM ET

Picture this: It's the evening of the Lady Gaga concert/Yankees game/yoga bootcamp. You bought the tickets months ago, saving up and looking forward to it. But tonight, it's blizzarding and you've had the worst week and are exhausted. Nothing would make you happier than a hot chocolate and pajamas, not even 16-inch pink hair/watching Jeter/nailing the dhanurasana.

But you should go, anyway, right? Because otherwise you'd be "wasting your money"?

Think again. Economically speaking, you shouldn't go. Welcome to "sunk costs."

In A Nutshell: People Are Bad At Cutting Their Losses.

"Sunk costs" is the economic principle that what you have spent is already gone. In other words, you could have spent $200 and had an unpleasant evening, or you could have spent $200 and had a great evening. Either way, you've already spent the $200.*

Robert Leahy, a psychiatrist and Director of the American Institute for Cognitive Therapy in New York, says, "A model of good decision-making is always based on future utility or future payoff. For example, a woman goes out and spends $300 on a dress and at home tries it on again but it doesn't fit, she looks awful in it. She may be reluctant to get rid of it because she may think, 'Oh my god, I put all this money into it!' She's honoring the sunk cost."

More often than not, people will waste money (and time) in order to justify costs they've already spent -- it's like throwing good money after bad. It applies to not only financial decisions, but professional and relational ones as well.

Know When To Bail.

One of the smartest moves we can make for our money and time is to know when to cut our losses. The irony of a sunk cost is that the more we have put into it, the harder it is to abandon it.

The first key is to recognize a sunk cost. Leahy advises, "Ask yourself, am I staying with this relationship or at this job, computer, house or this piece of clothing because I've already put money into it? That's sunk. That's all down the drain. If I had never made this commitment, would I go out and get it now? If the answer is no, then you probably should try to get rid of it as soon as possible."

According to Leahy, it's also important to know when to bail because of missed opportunities. "If I stick with this commitment to this past relationship, car, or house, am I losing out on other opportunities?" says Leahy. Your money and time can be better spent on new experiences you may not be as open to when you're hanging on to old things.

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Do a Sunk Cost Inventory of Your Life.

The end of the year is a great time to look back on the year and assess where some of your biggest "sunk costs" went, in terms of finances, time and energy.

Humans aren't rational by nature, and that's why so many businesses rely on subscription or pre-paid models, so that we feel "invested" and force ourselves to partake of their product or services. Be savvy to this. Start with these steps for the new year:

- In January, start living by the "sunk costs" principle. Let things go and let money "go to waste" if you're not really enjoying the things you've invested in.

- Keep track of how much money you have spent on things that are not bringing you enjoyment or fulfillment. See how much money you can save if you cut some of these things out of your life.

- Do this for small-ticket investments like package classes, subscriptions and items you've purchased, as well as big-ticket investments like house, car, job and relationships.

The principle of sunk costs isn't about living a life without commitment or follow-through. There are things we may not feel like doing in the moment but that we know, deep down, are good for our well being (exercise and healthy habits are just one example, and all worthwhile relationships require hard work).

But it is about getting in touch with what we truly want now, not what we think we have been wanting all along. It's about spotting our own patterns in honoring sunk costs and making better decisions in the future. Clearing the sunk cost "baggage" (financial and otherwise) from our lives will make room for better things. Because sometimes walking away is the wisest decision we can make.

A version of this post originally appeared on LearnVest.com

 

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