You’ve Sunk My Costs

by Team Dinks on May 12, 2010 · 0 comments

Economists tend to think about decisions in a different way than non-Economists. Sometimes our ideas make theoretical sense but are hard to put into practice. For instance, we’ll typically argue against pre-paying on a mortgage (given a reasonable interest rate, say less than 9%) because most American households hold unbalanced portfolios that are made up far too much of a primary real estate asset and not enough equities (for an example of this discussion, see this recent article Carl at Behavior Gap in the New York Times. Carl doesn’t discussion portfolio allocation, and herein lies a difference between the economist and non-economist.

While I wanted to highlight something about the stock market given the roller-coaster last week (mainly, to reiterate that short-term behavior in the stock market is entirely unpredictable and clearly not efficient, and those two things put together make any short-term trading strategy a gamble Vegas would love), I really wanted to talk about how we deal with sunk costs.

We face sunk costs each day. How we handle sunk costs tends to be, well, less than optimal. For an economist, a sunk cost is something that can’t be recovered. It is gone. Kaput. Thus, the economist would claim that the best thing to do with a decision (let’s say you already purchased movie tickets but then wonder if wine on your porch with friends would make a better night, and you can’t refund the tickets). Our psychological inclination biases us toward going ahead with our plans for the movie even if the wine/dine would be much more pleasing, because we already spent the money.

But, what economists would argue is that the sunk cost of the ticket shouldn’t impact your decision. But how often is this true in reality? Can we really ignore sunk costs?

Going back to the first paragraph, my advice to active investors (those who do short-term trades, or mess around with stocks outside a 401K or IRA) is to treat their investments as sunk costs. Once we buy, we really can’t do anything, it’s like fishing, either the fish bite or they don’t, and we hope we picked a good spot and bait. If we view these kinds of risks more like sunk costs, we might be less apt to rashly buy high and sell low, a mistake many made last Thursday due to the apparent trading glitch.

Sunk Costs are everywhere around us. They should not stop you from changing plans.

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