We naturally want to make the most of our purchases and avoid wasting anything when we spend money on a product or service.
This proves that we made wise financial decisions. However, sometimes forgoing the money we have paid for a product or service may be too much for us to bear, which may lead to making irrational decisions.
Here is where sunk cost fallacy comes into play. Let’s take a look.
What is a Sunk Cost?
The sunk cost fallacy implies that we are making illogical choices because we are considering factors other than the available options. The misconception has an impact on many facets of our life, which results in less than ideal results.
For example, you buy a meal at your favorite restaurant.
Midway through the meal, you notice your stomach is full. But you force yourself to finish the meal anyway because you don’t want to waste the money you spent. Regardless of whether we finish the meal or not, we have already spent money on the meal which cant be refunded. In other words, it’s a sunk cost.
4 Areas Where Sunk Cost Fallacy Sneaks Up on Your Finances
Sunk costs are common in daily life, therefore it’s not surprising that we keep running into the sunk cost fallacy. Here are some instances when it might snare you.
Bulk buying
Although buying in bulk might result in discounts, it might not make sense for you or your home. Any potential savings are lost if you don’t have enough room for nonperishables or don’t consume the perishables in time.
Club memberships
Just as a gym membership, golf club membership, or any other type of club membership isn’t worth much if you’re not using it, a paid membership to a bulk-buying club isn’t beneficial if you’re not buying in quantity.
Subscriptions
Sometimes we subscribe to multiple services just for the fun of it.
At times, we use the service only once and forget to cancel our subscriptions. Other times, we subscribe to multiple platforms that provide the same service. E.g. subscribing to Netflix and Amazon Prime. But take a hard look at how much you use these things.
Investments
From blue-chip stocks to crypto, the desire to hold onto your investments can sometimes be at odds with being on the losing end of a bad choice. Sometimes, because we don’t want to take a loss, we stay in an investment position longer than necessary which leads to more losses.
Why Does Sunk Cost Fallacy Happen?
We often let our emotions play a role in our decision-making, which leads to the sunk cost fallacy.
When we have already committed to an option, we are more likely to experience shame or regret if we do not make it a reality.
The commitment bias, in which we persist in supporting our previous choices despite fresh information showing they aren’t the optimal course of action, is related to the sunk cost fallacy.
We neglect to consider that the time, money, or effort we have already invested will not be repaid. Instead of considering current and future costs and benefits, which are the only ones that logically should matter, we frequently base our judgments on previous expenses.
Because humans are more prone to seek out gains than to prevent losses, the effects of losses seem far worse to us than the effects of gains. This contributes to the sunk cost fallacy.
One of the reasons for this is not following through on a decision.
Instead of reviewing our financial decisions in stages, we frame them together in terms of loss or gain, even if the subsequent decision not to continue to commit was actually in our best interest.
7 Ways to Avoid Sunk Cost Fallacy While Investing
1. Set investment goals.
Setting investing goals is the strongest defense against the sunk cost fallacy. Investors might achieve this by setting a performance goal for their portfolio.
For instance, investors could want their portfolio to outperform the S&P 500 by 2% over the following two years or to return 10%. If the portfolio is unable to meet these objectives, it could need to be reevaluated to determine where adjustments might be made to generate higher returns.
2. Attach financial goals to an achievement.
Having a long-term goal is crucial when establishing an investment strategy.
However, our goals will be clearer if they are tied to specific achievements or milestones. Rather than focusing on the amount of money you want to see in your returns, your objective should be toward an achievement like retirement or a home.
Once you begin basing goals on a percentage of returns, you are once more making choices based on prior expenses which could lead to sunk costs.
3. Review your investing strategy at least once a year.
Have a periodic review of your investment strategies to ensure they are meeting your pre-set goals.
Refrain from using a strategy merely because it has previously been successful. Markets evolve, and so must your strategies. Make sure that the future, not the past, is the focus of your investments.
4. See if your money can do better elsewhere.
Take a hard, objective look at your losing investments and see whether you could be doing better elsewhere.
Sticking with a losing asset or investing plan means giving up the potential gains you may have made with an alternative strategy, in addition to committing to a position that isn’t functioning.
5. Commit to a plan when trading.
It might be difficult to avoid the sunk cost fallacy when markets are volatile and trade goes against you.
Making a trading strategy in advance that outlines your goals and how you intend to achieve them is one method to maintain discipline.
These should be important components of your trade strategy:
- trading time horizon
- entry and exit strategies
- position size
- trade performance evaluation
Keep in mind that losing trades does occur.
The objective is to have more profitable transactions than unsuccessful ones. Or to make more on your winners than you lose on your losses, rather than to win on every trade.
6. Have predetermined exit points.
You should have predefined exit points for your investments.
For example, you could decide to sell a stock if it declines and doesn’t recover after a given period, or you might decide to diversify out of an investment if it comprises a particular percentage of your portfolio.
If you trade, you might want to think about utilizing limit orders, stop orders, or stop-limit orders to assist you to trade more systematically. Each order type may be used in specific market circumstances to achieve specific objectives, such as executing transactions at prices you set when markets are choppy.
7. Recognize the value in losses.
Think twice before increasing your investment if it is in a losing taxable account.
Strategies like tax-loss harvesting allow you to utilize depreciated assets to lower your tax obligation. To do this, you must sell a losing investment to balance gains from other investments in your portfolio that are taxable and then purchase back a similar but different position.
Final Thoughts
The sunk cost fallacy arises because we frequently stray from logical conclusions due to our emotions. We are prone to follow through on a decision that we have invested in, even if it is not in our best interest because we want to prevent unpleasant feelings of loss.
Understanding the sunk cost fallacy’s foundation can help you fight the consequences it has on your spending and quality of life. You can even discover strategies to reduce your expenses and increase your savings.
