I went to a movie some time ago and it was clear within the first 30 minutes that this was going to be a BAD movie. I knew the movie was over two hours. I also knew that I already paid a bunch of money to get into the movie and buy my snacks. So now I'm stuck; do I suck it up and keep watching this crappy movie because I've already paid for it or leave because it's not a good use of my time?
The answer is...leave.
Sunk costs are costs that have occurred in the past, and that we can't recover. Costs do not need to refer to money. Costs could be time we've already spent or energy we've already put forth.
We often makes the mistake of including sunk costs in our analysis of the future. For example, we might say that we've already paid the money for the movie ticket so we have to get our money's worth.
The better way to think about that is we paid for our right to watch the movie in the theater, but we don't have to. Once we pay the money to the theater, it's gone. Our decision now has nothing to do with the cost of admission. Our decision now is a) do I want to waste my time watching a crappy movie, or b) do I want to spend my time doing something I enjoy. In neither "a" nor "b" do we consider what the cost of the ticket was.
College Textbooks: One example that might be familiar is college textbooks. When I was in college I had to go to the bookstore each semester and rummage through the place looking for all the books I needed for my classes. This activity ended up costing me hundreds of dollars. After finals we had the opportunity to sell our books back to the bookstore so they could sell them as used to the next student. Often times they would offer $15 for a book I paid $100 for. My initial response was always something to the tune of, "Are you crazy? That's $85 less than I paid for it!" I was hung up on the sunk cost of $100. The proper way to think about that decision is, "do I want $15 or this book?" What I paid for it is irrelevant.
Investments: Another example is some kind of investment, which could be a stock or a rental property. The type of asset doesn't matter. Imagine you purchased an investment for $1,000 two years ago. A couple years later you learn that the value of that investment is $400 and you have to decide whether to sell or keep the investment. It's very tempting to tell ourselves that we need to hold onto it until we break even, because we get hung up on the purchase prices. But the real decision comes down to asking ourselves if that investment is the best use of those dollars. Would be buy that investment again at $400? If we wouldn't buy it at $400, we shouldn't hold it at $400. If we would buy it, we should keep it. It's not a matter of how much of a loss we took; it's a matter of is that the best use of our $400?
Event Tickets: Seth Godin asks us to consider an example where a friend gives you a ticket to a popular event that you are very interested in attending. On the way to the theater someone offers you $1,000 for it. Alternatively, the same friend gives you $1,000 and as you are out on a walk someone offers a you a ticket to the same event for $1,000. Would you go to the show in the first example and not in the second? If so, you, like many others, are getting hung up on sunk costs. In both cases you can either have $1,000 or go see a show. The order in which you received the two offers should not matter. If you have the tickets in hand and someone offered you money for them, that the same as if you had the money and you found someone selling tickets. We get hung up on the sunk costs of whichever happened first.
Sunk Costs Are Hard To Ignore
It's easy for me to tell you to ignore sunk costs. But even if you knew how to spot all the sunk costs, it's still very, very difficult for us to do. You might know that sunk costs matter and should not be considered, but tell that you yourself when you are frustrated with that project you're working. "I've already put so much time into this!" It's even more tough when it's more difficult to spot the sunk costs, like in the event ticket example. If you find yourself hanging onto sunk costs, you're not alone.
The Past Is In The Past
By ignoring past decisions and thinking about only what needs to considered going forward, you will be well on your way to money health.
Dan Ariely, Jeff Kreisler: Dollars and Sense
Michael Lewis: The Undoing Project
Seth's Blog: Good decisions (and sunk costs)
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