Humans have all sorts of weird inner thoughts that affect our decisions. These tendencies are known as cognitive biases and they are likely keeping you from becoming rich and staying happy.
One bias that hurts us the most is the sunk cost fallacy or the sunk cost effect. This is when people continue to increase their investment into something based on how much they’ve already invested.
You’ve likely felt this before. If you’ve ever said the phrase “Yeah, but I’ve already spent this much money, gotta keep going now” or “I don’t want to, but I’ve already come this far”, then you’ve been a victim of the sunk cost effect.
This effect causes us to do things we wouldn’t normally do if we weren’t already invested. It causes people to stay in homes they don’t like, finish degrees they don’t want and hang onto stuff they don’t use anymore. We justify it in our minds because we don’t want all that time and money to go to waste.
The problem is that in reality, we’re just wasting more time and money by continuing to pour into it.
If you want to be rich and be happy you must learn to not let your past mistakes impact the decisions you make moving forward, even if that means taking a loss.
Let’s look at 2 examples of how the sunk cost effect can keep you from a rich life.
Hanging onto a car for too long is something most people end up doing. Unfortunately, our culture tells us that you should purchase a car based on the amount of monthly payments that you can handle. So most mid 20-somethings fresh out of college put getting a brand new car on the top of their priority list.
Then they end up buying way more car than they can really afford. The problem is, even if they realize this afterward, they probably won’t do anything about it.
The sunk cost bias kicks in fast when it comes to cars. People know that cars take a huge cut in depreciation as soon as you drive them off the lot, so they’re scared to sell them. They think “I can’t afford to take the loss” or “but I’ve already put so much into it in car payments.”
The problem is in reality, you can’t afford to NOT take the loss.
Here’s an example:
Imagine you buy a $30,000 car with $3,000 down. You take a $27,000 loan for 60 months at 3%. This loan would be a monthly payment of $485 and would cost $29,109 over the whole life of the loan. Putting the total car cost up to $32,109.
Let’s say that 1 year after you bought the car you realize that you really shouldn’t have bought that car at all, but at this point, you just feel like there’s no way you could afford to take a loss.
Let’s see if that’s really true.
After a year’s worth of payments and an initial downpayment of $3,000 you now owe roughly $21,355 on the car. Typically cars lose around 20% of value within the first year, so your selling price for the car is $24,000. You sell the car and make a profit of $2,645.
Now you can use that money to make a downpayment on an $8,000 car. Taking a loan for $5,355 for 24 months at 2.8% gives you a monthly payment of $230. And now you will have the car paid off in 2 yrs instead of the 4 more years it would’ve taken for the original car.
Here’s where it gets interesting, now take the rest of the money you were using for your original monthly payment and invest it into a U.S. stock market index fund averaging 7%. This means you will invest $255 monthly for two years. Then you can invest the full $485 for two more years after your car is paid off. At the end 5 years from when you bought the first car, your money will now be worth $18,827!
So, at the end of 5 years wouldn’t you rather have the older used car and almost $19,000 in your pocket, rather than $32,000 gone forever and a new car that you’re probably tired of by now?
The whole point here is that taking the hit on depreciation seems like a loss at first. But if you take action to correct it, you’ll come out ahead in the end.
Don’t let a stupid decision in your past direct the decisions you make going forward.
Not only does the sunk cost fallacy affect our thinking when it comes monetary investments, it also affects our time investments.
Over half of the people in this country are unsatisfied with their jobs. But they don’t do anything about it.
Odds are, you’re probably one of them.
Oh sure, you complain every day about the boss, the coworkers, the work hours, or any number of things. But do you actually do anything about it?
One of the problems is that most people feel like they’ve invested too much time into a career or getting a certain degree that they can’t possibly do something else.
The problem with this thinking is that it robs you of doing something you’re passionate about and really enjoy. You’ve got to realize that it’s sunk cost. It’s sunk time. It’s already gone and you can’t do anything about it.
You’ve already gotten the degree, you’ve already taken those classes, you’ve already worked 10 years in that field, but that doesn’t mean you have to spend the next 10, 20, or 30 years doing the same thing.
It’s gone, you need to focus on controlling the only thing you can control, which is what you do moving forward.
Let me ask you this, if you hadn’t already gotten the degree or spent that many years in that field, would you choose to do what you’re doing right now?
If the answer is no, it’s probably time to start looking for other opportunities.
This may mean taking a pay cut or going back to school to get an extra certification. It might mean moving or learning something completely new.
It won’t be easy but having a job you enjoy is worth more than the money you will lose. If you hate your job, don’t let your past decisions on career choice affect your future job satisfaction. You’re going to be working in this field for a long time, it’s just not worth it. You only get one life, don’t waste it somewhere you hate.
Is Your Sunk Cost Bias Holding You Back?
All of us will experience this effect at some point in our lives. The key is to not give in.
This fallacy shows up in big areas like owning a home, buying a car, or changing careers. But it also shows up in little ways too, like deciding to get rid of clothes you don’t wear anymore or selling that bike you haven’t ridden in years. We never use them, but we don’t want to give them up because we’re invested in them.
We hate the idea of giving up something that we feel invested in, even if it means we’re going to gain something else.
This is actually getting into another one of our cognitive biases called loss aversion, which is the idea that people feel the pain of loss twice as intensely as the joy of gain. We hate the idea of giving something up or taking a loss. We despise it more than we love the potential gain.
This makes it very difficult for us to cut our losses and move forward.
But if you want to be rich, you’re going to have to accept your losses sometimes in order to not lose more.
And if you want to be happy, you’re going to have to forget about wasted time and learn to switch up your plans.
What sorts of things does the sunk cost fallacy hold you back from? Do you have trouble taking losses and moving forward? Are you letting past decisions affect your future
Let me know in the comments below!