How Failing to Recognize Sunk Costs Keeps Us Stuck in Bad Investments
A few weeks ago, I had tickets to an NFL game. It was freezing that day, and all my friends backed out. But I didn't want to waste the $70 I'd spent on the ticket. So I went to the game -- and was absolutely miserable. I hate to admit it, but my friends were right.
I didn't even have much vested interest in the teams playing. Nor did I have a good time at the game; I would've been much better off just watching it from the comfort of my couch. But I was obsessed with not having wasted the money I spent on the ticket. In hindsight, I know I should have recognized that it was a sunk cost, chalked up the loss and moved on. I shouldn't have let it cloud my judgment.
But when it comes to to sunk costs, our instinctive opposition to "wasting money" we've already lost can hurt us in many ways. In investing specifically, it can make you hold on longer than you should, and cost you even more.
Wait: What Is a Sunk Cost?
A sunk cost -- money that we've already spent, and that we can't get back -- biases our future behavior. It weighs on our minds and keeps us from making rational decisions. Sunk costs keep us in investments that we otherwise would've abandoned long ago. We use sunk costs to justify our past choices, but they can keep us from moving forward.
And whether we realize it or not, sunk costs are everywhere. If we look hard enough, we can see them in a lot of our decision-making. I can't even begin to count the number of stocks I've bought that have lost money. I've been stuck with the choice of either selling for a loss or trying to buy more to lower my cost basis -- which can be throwing good money after bad.
%VIRTUAL-WSSCourseInline-561%But the money that you've spent on a stock purchase shouldn't factor in your next decision. You should know what conditions would lead you to sell a stock before you buy it. What if the reason you thought it was going up doesn't pan out? What if the company has a bad quarter? Or the company's management decides to go in a different direction than you expected? Before you even buy a single share of stock, you need to have an exit plan.
You have to sell your stocks -- or hold them -- based on rational criteria. The amount of money you spent when you bought them should not be a factor. That money is gone. It's a sunk cost. Ignore it, and consider only whether an investment is a good or bad deal looking ahead when you make the next decision about what to do with it.
Time Shares: A Classic 'Sunk Cost' Conundrum
Have you ever bought a time share? If so, you're not alone -- millions Americans own them. The problem is that they're typically poor investments that lock buyers into long-term agreements to visit the same vacation destinations each year. They're incredibly illiquid, and they're expensive.
Time shares also come with hefty maintenance fees that you have to pay every year, even if you don't use your annual points toward a vacation. Many people dream of getting rid of their time shares, but they can't -- or think they can't, because of their sunk costs.
%VIRTUAL-article-sponsoredlinks%So why do we continue to hold onto these poor investments? It's because we've already spent so much money on them; we dread losing the "benefit" from it -- even when it's not such a benefit at all.
Under Water and Treading Water
Despite the fact that the money I've put into my house is a sunk cost, I refuse to sell my home. It's irrational, I know, but I just don't want to lose on the investment -- and if I were to sell today, I'd be out over $25,000 because I'm upside down on my mortgage.
Instead, I'm an accidental landlord -- scared into inaction by the idea of realizing the loss on my big real estate investment. I just can't bring myself to accept that the loss has already happened. Of course, the money I've put into that house is a sunk cost, and it shouldn't factor into my decision on whether or not to sell it. If only I could follow my own advice.
Be wiser than me. Don't let sunk costs lock you into bad investments. When it's time to sell, cut your loses and sell. And don't look back.
Hank Coleman is a financial planner and the publisher of the popular personal finance blog, Money Q&A, where he answers readers' tough money questions. Follow him on Twitter @MoneyQandA.
More From Hank Coleman: