Examining the sunk cost fallacy. How hard is it to change direction?

Throwing Good Money after Bad

by Helen Young

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Have you ever noticed how incredibly hard it is to pull the plug on a bad investment? While this may be true for most people, I think we tightwads of the world may have an extra tough time letting go. Given our aversion to wasting anything, it can be extremely difficult to admit when we've done it.

My first insight into how tightly I could chain myself to a bad investment came when I was still just a kid. My parents had insisted I play an instrument. I'd chosen the clarinet, and I had to practice for 30 minutes a day. After years of this daily torture, it was clear to everyone involved that I would never be a clarinet virtuoso. Even the family dog howled in agony when I played. My parents finally relented and told me I could quit. I, on the other hand, gritted my teeth and kept going for another three years. Not because I liked it (I hated it, actually) but because I had already put in so much time that I couldn't bear to stop.

Behavioral economists will tell you that this is a known and extremely common tendency. (Too bad for my dog that nobody explained this to me in junior high.) For example, Gary Belsky and Thomas Gilovich address this mental pitfall, among many others, in their wonderfully insightful book Why Smart People Make Big Money Mistakes. They refer to it as the "sunk cost fallacy."

According to Belsky and Gilovich, "This tendency is harmful for the simple reason that past mistakes shouldn't lead you to make future ones. The past is past, and what matters is what is likely to happen from now on. So a person who turns down an offer for a house because the bid is lower than the original purchase price may be following one blunder (paying too much in the first place) with another (not getting out while the getting is good)."

Below are some places where you may be falling prey to the sunk cost fallacy.

  • Retaining assets that have lost their value - Hanging onto an unsuccessful business, a car that frequently breaks down, or a stock that's plummeting in value? Reassess that asset's true value now (both financially and emotionally) to help you determine whether to hold tight or jump ship.

  • Sticking with bad financial choices - For years, I failed to participate in a plan at my company that would have allowed me to buy stock at a discounted price. Although this meant turning down a virtually guaranteed profit, failing to put the necessary money aside in the first year I worked there made it easier to justify skipping this during each subsequent year. It took me a decade to acknowledge the money I'd already wasted and take action to reverse my decision.

  • Holding on to clutter - Got closets full of dated clothes, old toiletries, mismatched Tupperware, or other stuff you don't use? Make a decision to use it now or donate, recycle, or sell it. Clutter may apply to your investments or financial records as well. If you've got a bunch of different little 401k funds from past employers, for example, it may behoove you to consolidate.

  • Shooting your happiness in the foot - Busting your butt for an apartment, nice clothes, or other material goals may have seemed like a reasonable idea when you were younger, for instance, but remember to regularly examine how much satisfaction your priorities are bringing you today. Continuing to climb the corporate ladder only makes sense if the top is still where you actually want to be.

If after taking stock of your investments in both time and money you discover lots of places where you're throwing good resources after bad, don't be too hard on yourself. If your old dog died years ago, your new one will still thank you for ceasing to play the clarinet. And as Belsky and Gilovich point out, sometimes the sunk cost fallacy actually works for us. One example they cite is gym memberships. If your aversion to losing your original investment provides the motivation you need to pry yourself off the couch, then that's a good thing. At the end of the day, the more we can learn about our own spending biases, the more skillfully we can use them to help us prosper.

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