As an undergraduate student I took an economics course from an extraordinary professor. He was so good that after I had completed the course, I sometimes went back to sit through his lectures again. That economics course provided more and better decision-making tools than many of my MBA courses on business decision-making. One literally life-changing secret I learned in economics is to recognize and discard “sunk costs.”
A “sunk cost” is a cost that has already been incurred and thus cannot be recovered. The magic of understanding sunk costs is that once a cost is sunk, it should have no bearing on future decisions.
- Let’s say that you sign up for a non-credit painting class at the community center. You pay a non-refundable fee of $100 for eight class sessions. After three classes you realize that you hate painting. You face the next class with growing dread, but you force yourself to go because if you don’t you will have wasted that $100.
That fear of wasting the money is the lie of the sunk cost. The $100 is gone, whether you go to the next class or not. The $100 is a sunk cost. It cannot be recovered; it cannot be spent again; it cannot be wasted. No matter what you do, it is gone.
As a sunk cost, it should not be part of your decision to continue the class or not. Your decision should be based on what you expect to get out of the class. If the benefit you expect from continuing the class (learning to paint, honoring a commitment, etc) is greater than the cost you expect from continuing the class (discomfort, missing out on an activity you prefer, etc), then you should continue. If the expected cost exceeds the expected benefit, you should drop it.
- Here’s another example. You’re at a restaurant and have enjoyed a large and delicious meal. Halfway through dessert your stomach feels far too full to finish. You keep shoveling that enormous brownie into your mouth, thinking, “I need to finish because I’m paying good money for this.”
That is the lie of the sunk cost. At that point, finishing dessert brings more pain than pleasure, and doesn’t make any difference to your final bill. If you’re not enjoying it, it’s not good for you, and it’s not saving you money, why do you keep eating? Because you don’t want to have wasted the money you paid for dessert.
How often do we make irrational decisions based on sunk costs to which we should pay no attention? All the time.
How do we avoid it? The secret is to think forward, not backward. What you have paid for something (whether money or some other price) is a sunk cost. What you choose to do now should be based on the future costs and benefits of your choice, not something that happened in the unchangeable past. It takes some practice to recognize what goes into our decisions, but when you really look at your deciding factors, it’s amazing how often some of the costs are simply sunk and should be irrelevant.
That’s all very well, you say, but isn’t it a little ostentatious to call it a life-changing idea? And what does it have to do with budgeting and debt repayment anyway? Let me illustrate with a few stories.
- A friend recently took her two kids to a dinosaur expo in the city. The entrance fee for the family was $68, a strain on their shoestring budget. When they arrived, she realized she had to pay another $12 for parking. Then they got inside and found that the expo was really lame. She explained, “I don’t usually buy carnival food, but I had already spent all that money, so I figured I had to make it a good experience.” After food, games, and trinkets, she ended up spending over $200.
Her sunk cost was the cost of parking and entrance, and it changed her decision paradigm. If the expo had been free, she would never had paid $120 on food and gewgaws. However, because she had already laid out some cash, she decided to spend more to redeem what she had already spent. She let the sunk cost make the decision for her.
- Another friend has decided to get rid of their $80 cable subscription. He sees that the cable bill is unsupportable, and they watch most of their shows on Netflix, so he’s planning on letting the contract run out in 9 months. He could cancel the contract now and pay a two-month early termination fee, but he hates the idea of paying a penalty, even though he would save $560 by paying for just two months instead of nine.
His sunk cost is what he’s paid into the cable contract thus far, plus the $160 early termination fee. By signing up, he had committed to pay at least $160. Neither his previously paid cable bills nor that $160 will ever come back to him, no matter what decision he makes. Those are sunk costs and should not figure into the decision about when to quit cable. If he had to make the decision about entering a cable contract today, he would not sign up for it, but he is allowing his sunk cost to convince him to do just that by opting to remain in contract instead of cancel it.
- A few years ago, a friend purchased a new car and picked up a corresponding car loan. A year later, he decided to go back to school to switch careers. His car was depreciating faster than he was paying off principal, and he had to put premium gasoline into it as well, creating higher fuel costs. He knew he needed to sell the car. He could sell it at a loss now, or keep paying on it and sell it at a greater loss later. He chose to keep the car as long as possible so as not to have wasted all the money he had already put into it.
His sunk cost is what he has already paid into the car. That money is gone, never to return. It should not be part of the decision about what to do in the future. The decision should be based on the cost of selling the car and having to purchase a replacement, versus the cost of keeping the car.
I want to emphasize that I’m not condemning any of these people. I’m trying to illustrate that we place a great value on our sunk costs, when in reality, they have no value. As humans, it’s hard for us to give up something we’ve sacrificed for, and that’s not all bad. Sometimes, though, it gets in the way of sound financial decisions.
I also want to emphasize that I know it’s not all about money. The most important costs and the most important benefits have nothing to do with money. Even when dealing with these non-monetary factors, the idea of disregarding sunk costs still applies. When we pour something like time, devotion, love, or physical pain into a project, that project becomes valuable to us, and the cost to us of replacing the project is increased.
Often though, as in a cable plan or gym membership, those non-material factors are minimal. In those cases, a good decision can be based on something as mundane as monetary costs, as long as we’re willing to leave behind our fondness for the money we’ve already spent and can never get back.
Recognizing and discarding sunk costs in future decisions is a powerful way to make more solid personal finance decisions. Whether the idea is life changing or not is up to you. For me, knowing that I can discard my psychological attachment to sunk costs is liberating. I suspect that for Stephanie, who can predict my calling “sunk cost” on a decision, my commitment to erasing sunk costs is a little bit comical. For you, you’ll just have to try it and see.