We all know not to throw good money after bad, yet we do it anyway. So why do we do it? We do it because sunk costs cloud our judgment, making it difficult for us to think rationally.
What is a sunk cost?
A sunk cost is money you’ve spent that you can’t get back. Examples would be non-refundable tickets or food from a restaurant. Sunk costs are not things like insurance premiums. It’s possible to pay insurance premiums for years before making your first claim, as is often the case with homeowner’s insurance or car insurance.
What is the sunk cost trap?
The sunk cost trap is the irrational behavior of continuing to spend time and/or money on something that’s not benefiting you.
Why do we fall into the sunk cost trap?
We fall into the sunk cost trap because we don’t always think rationally. We often let our emotions cloud our judgment. Previous investments of time and money cause us to become attached to purchases we’ve made in the past. And the more we spend, the more we become attached.
We often feel like we’re past the point of no return. We’ve come this far, why stop now? We think that we must stay the course, even if we don’t like the path we’re on. We can be terrible at cutting our losses.
We see the price of an item as its value. I was watching a TV show where a couple unknowingly bought a haunted house. After discovering their house was home to evil spirits, they still decided to stay. They had invested all their money into the house, the bank wouldn’t take it back, and they wouldn’t accept a total loss. I understand that this is a fictional story, but we see the same thing in real life.
Let’s say you have a $300,000 mortgage on your home. The housing market crashes and your home is now worth $150,000. You’ve already paid close to $200,000 on the mortgage already. What would you do? During the 2008 housing marketing crash, many people decided to default on their mortgages. The keyword is “many”. That means some people were willing to pay more for their homes than it was worth. It can be difficult to walk away after you’ve been paying your mortgage faithfully for over 15 years.
The more responsible we feel for a bad purchasing decision, the more we cling to it. We tend to rationalize our bad choices while being able to recognize mistakes made by others. You’re more likely to sell the house from the previous example if it was your decision to buy it in the first place. It may be a more difficult to walk away from the house if you inherited it from your parents. You didn’t make the decision to buy the house that has sunk in value, but you don’t want your parents’ money to go to waste.
We don’t want to admit that we’ve made a mistake. If you bought a new car and posted it all over Facebook, but now you can’t afford the payments, you should take it back. Often people won’t do this because they fear some form of public humiliation.
We can have a “don’t waste” mentality. We stuff down that one last piece of broccoli or flounder. We don’t even like flounder, but we ordered it, so we’re eating it. We have to get our money’s worth, right?
Scenarios
You’re 30 minutes into a boring movie showing at your local theater.
Sunk cost trap: You might as well watch the movie. You’ve already bought the ticket. You’ve even bought snacks and refreshments. We all know how expensive movie theater popcorn can be. You should stay right there and sit through the terrible movie and get your money’s worth.
Truth: You should leave. Sticking around to do something enjoyable because you don’t want your money to go to waste will lead to an even bigger loss. A loss in time. It hurts a lot more to waste time and money, rather than just money. We can’t get back lost time.
You’re at an expensive restaurant and the food is terrible.
Sunk cost trap: Don’t let the food go to waste. Sure, it doesn’t taste all that great, but food is food…right? Fill your belly and be on your way.
Truth: If you don’t like the food, don’t force yourself to eat it. On another note, stop eating when you’re full. The point of paying for the meal is to enjoy it. You’re not gaining anything buy eating that last piece of broccoli.
You drive a cheap unreliable car that constantly needs fixing.
Sunk cost trap: You’ve already bought the car. Sure it has some problems, but they’re really cheap to fix. It would cost too much money to buy a newer car. Who can afford one of those?
Truth: You need a new car. I fell into this trap in the past. I paid twice as much for a used car as I should have. I didn’t do my research and it cost me. The car ended up having one problem after another. After about fix #3 (or #4) I decided it was best to sell the car for junk. My money was better spent on a more reliable vehicle.
You bought a non-refundable plane ticket, but realize now isn’t a good time to take a vacation.
Sunk cost trap: Take the vacation anyway. Why lose $300?
Truth: The money is gone either way. If now isn’t a good time to go, then don’t go. My wife and I bought plane tickets to take a vacation and ended up changing our minds. We understood that getting a hotel room, rental car, etc. would cost us even more than the money we were losing by not going on the trip. You need to look at the big picture.
You’re on vacation and you don’t like the hotel you’re staying in.
Sunk cost trap: Tough it out. The room is already paid for and the cost is non-refundable.
Truth: Go to a different hotel. Why go on a vacation and be uncomfortable? During our trip to Thailand, we stayed in a budget hotel that wasn’t the cleanest. We decided that it’d be better to stay in a more expensive bungalow on the beach instead.
Key Points
- A sunk cost is money you’ve spent that you can’t get back.
- The sunk cost trap is believing that you should continue to invest time or money into something when the best thing to do is to walk away.
- Avoid throwing good money after bad. Don’t let the money you’ve already invested in something cloud your judgment. Know when to cut your losses.