What Is Sunk Cost?

sunk Cost - investing terms

There are some economic terms most of us know and understand, such as supply and demand. And there are other terms we will probably never even run across, like implicit logrolling and a Kondratieff cycle.

In between, though, are all the terms you need to know to help with everyday financial decision making. To mark Financial Literacy Month, throughout April we'll be unpacking key economic concepts -- the ones that affect your everyday finances and investments -- to help you make the smartest choice with every dollar decision you face.

Today's term: sunk cost.

As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.

Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.

Companies need to keep sunk costs in mind when they plan projects and execute strategies. It's easy to think that once they have spent money buying another company or perhaps building a factory or coal mine, they should stick with it, even if it's not turning out to be as productive as initially expected. If they disregard the sunk costs, though, they can make more sensible decisions about where to spend their next dollars -- ideally on their most promising options.

Sunk costs come into play frequently when we invest in the stock market. Maybe you spent $5,000 on shares of Scruffy's Chicken Shack, and those shares are now worth $3,000. Frustrated that you've lost $2,000 you hang on, even though you're no longer very confident in Scruffy's future, waiting and hoping that the shares will rally and you'll make your money back.

That may seem reasonable, but it's not. View the $2,000 lost as a sunk cost and you'll see that you still have $3,000. You can leave it invested in that same stock, but you can also move it into another investment, ideally one in which you have much more confidence. You are, after all, more likely to earn $2,000 or more in your most promising ideas than in Scrufy's mediocre ones.

Related term: opportunity cost.