Although it might surprise you, psychology plays a significant role in how you manage your finances. In fact, there are numerous cognitive biases that cost us money, and we’re sometimes our own worst enemy.
There are also plenty of examples of how thinking patterns can derail our financial decision-making. For some, overconfidence might lead to making risky, speculative investments. For others, a shopping addiction could be an expensive coping mechanism.
Whatever the case, it’s clear that our minds have a massive influence on how we handle money. However, if there’s one cognitive bias that can lead to complete financial ruin, it’s the sunk cost fallacy.
If you want to protect yourself against this harmful line of thinking, you need to understand what the sunk cost fallacy is and how you can recognize it before it leads you to make bad decisions.
What Is a Sunk Cost?
In economics, a sunk cost refers to a cost that has already occurred and that you can’t recuperate. In other words, a sunk cost occurs when you spend money on something without any chance of recovering that money, even if you desperately want to.
There are plenty of examples of sunk costs, mostly relating to business decisions. Some examples include:
- Spending money on marketing for your small business that you later shut down
- Spending money on research and development and then canceling the project partway through
- Spending money on training new employees only to end up firing them
However, consumers can also experience sunk costs of their own when they spend money on something and can’t recuperate their funds in the event they change their mind. In these cases, consumers often engage in the sunk cost fallacy, which is undeniably one of the most costly cognitive biases.
The sunk cost fallacy occurs when people continue investing time and resources into something because they are afraid of losing everything if they stop that behavior. In other words, people are likely to continue spending money on something to sustain it if they have previously invested money into it.
The reason we experience the sunk cost fallacy has a lot to do with loss aversion. Psychologists like Amos Tversky have found that, generally, people would rather take risks to avoid loss rather than taking risks to gain something.
As a result, people often take a foolish course of action and try to preserve their initial investment rather than letting go. Economists also refer to this as an escalation of commitment.
As an example, consider the last time you ordered too much food at a restaurant. Did you still eat the food, despite your discomfort, or did you throw it away? Chances are, you’ve eaten too much on some occasions because it feels wrong to throw food away after you spent money on it. It’s a sunk cost.
How The Sunk Cost Fallacy Costs You Money
Overeating at a restaurant is a fairly harmless example, but it highlights how we think. There are several other real-life examples of the sunk cost fallacy that can have a more dramatic and harmful impact on your finances.
1. Sticking With Bad Investments
One of the most harmful examples of the sunk cost fallacy is continuing to invest money into something that is a bad investment because you don’t want to lose the money you already put into it.
This could involve multiple kinds of investments. For example, you could continue investing in penny stocks even with horrible losses just to avoid admitting defeat.
Similarly, if you bought into cryptocurrency during a bubble and lost much of your initial investment, you might continue investing in Bitcoin and other digital currencies — even as their values collapse — in hopes prices recover.
The psychological trap here is that you hope investing extra money can recoup your losses and even result in profitability. Ultimately, the fear of an absolute loss makes it hard to bail out and admit an investing mistake, even though cutting your losses is often the best strategy.
How to Avoid This
Learn the basics of investing before you start, and make informed decisions based on stock market research rather than emotional investments. If you dabble with speculative investments, only do so with discretionary income and have a cutoff point for how much you can invest.
2. Doubling Down on Gambling
In the U.S., gambling is a $300 billion dollar industry. Some professional players make their living behind a blackjack or poker table. However, for the average player, gambling is a losing proposition because the house has winning odds.
Despite these odds, millions of people around the world still gamble. For some, gambling might take the form of trying to win the lottery. For others, casinos or sports betting are their gambling methods of choice.
Whatever the case, gambling isn’t necessarily wrong if it’s legal and you’re doing it with entertainment in mind — and sticking to a budget. However, gambling can become an addiction, and it’s also a common example of how people fall prey to the sunk cost fallacy.
A prime example of the sunk cost fallacy in gambling is doubling down after losing a bet or — even worse — a series of bets. After all, games like roulette can see you double your money with a lucky spin, potentially reversing your fortune for the night if you’re in the hole.
In reality, this is the worst thing you can do when gambling. The house is always favored, and statistically, doubling down isn’t a rational decision.
How to Avoid This
Choose to abstain from gambling altogether or to have a cutoff point where you walk away once you lose a predetermined amount of money.
3. Not Canceling Trips
If you’ve ever bought tickets to an event like a concert only to realize it’s inconvenient to go when the date arrives, you’ve probably struggled with the sunk cost fallacy.
On one hand, if you bail on an event, you usually lose all of the money you spent on tickets. On the other hand, canceling a trip is sometimes the best financial choice, especially if you’re on a tight entertainment budget.
We face these sorts of decisions all the time. It can be a weekend getaway, a wine tour with friends, or even international travel plans. When you consider the time you spend researching a trip and the cost of tickets, it’s sometimes hard to walk away, even if it’s in your best interest.
This is a classic example of the sunk cost fallacy in action. Oftentimes, this trap leads to you begrudgingly going on your trip anyway, having a worse time, and spending money you can’t afford to — hardly a winning solution.
How to Avoid This
Firstly, always book travel plans with a travel rewards credit card that offers trip cancellation protection. You can also consider travel insurance if you want to protect yourself from cancellations.
Finally, always think of the bigger picture. Missing one concert or event won’t be the end of the world, and you need to put your finances first sometimes if you can’t afford a trip.
4. Sinking Money Into Your Car
Car repairs are an inevitable part of owning a vehicle. The simple fact is that, new or used, every vehicle has a lifespan and you have to spend money to maintain your car.
However, there’s a difference between spending money on basic DIY car maintenance and sinking money into a clunker. If you’ve already spent thousands on repairs, this sunk cost trap might make you feel as though you need to continue spending to fix your car rather than selling it for scrap.
Plus, if you have an emotional attachment to your vehicle, it might be tough to let it go.
In reality, you need to conduct an honest cost-versus-benefit breakdown for your vehicle spending. How much money have you spent to date on repairs, and what repairs are coming up? Additionally, will more repairs significantly extend the life of your vehicle, or are you taking a gamble?
If you’re honest with yourself, you might find the best solution is to sell your car and to find a more affordable, reliable model.
How to Avoid This
Keep an accurate record of your vehicle expenses so you know how much you spend on repairs. Don’t be afraid to ask multiple mechanics for their recommendations about whether the car is worth fixing before you decide to spend more on repairs.
5. Staying in Bad Relationships
Although this isn’t a purely financial example, staying in a bad relationship because it’s too hard to break up is a common example of the sunk cost fallacy at work. After all, years of dating or marriage can make you feel like you’re stuck.
Plus, it sometimes seems easier to spend time and energy trying to fix things rather than starting over.
However, a bad relationship isn’t just unpleasant for both parties. In fact, an unhealthy relationship can lead to financial problems like increased financial stress, arguments about money, and even divorce. The added stress can also impact your mental and physical well-being, distract you from your career, and generally worsen your personal life.
There’s nothing wrong with putting in the energy to try to repair a relationship. However, at some point, you need to know when to walk away and to look after your best interests before you make serious or irreversible commitments to a relationship that’s making you worse off.
When you consider how costly divorce is and the fact that you don’t deserve to stay in a bad relationship, the choice is clear.
How to Avoid This
There isn’t a right answer for how to avoid this because every person and every relationship is different. People make mistakes when getting into relationships, but the bigger mistake is staying in one when nothing you try improves your situation.
Your best defense is to get on the same page with your partner before serious commitments like marriage, moving in together, or having kids.
Other Tips for Avoiding the Sunk Cost Fallacy
Knowing common examples of the sunk cost fallacy helps you avoid making mistakes for future decisions. Additionally, there are several general tips to keep in mind to protect your finances.
Take Time to Make Decisions
Rushing through important financial decisions is one of the easiest ways to make poor choices. People fall for the sunk cost fallacy because they usually exaggerate the financial consequences of walking away.
In reality, if you consider your options, you might find that your situation isn’t as bad as you think. Taking time to think about a decision with a clear head often leads you to a better outcome.
Ask for Second Opinions
Another easy way to make the right financial decision is to ask for advice. If you invest time and money into something, it’s hard to keep your opinion unbiased.
For example, if you’ve sunk money into a car you love to drive, you might place a higher, partly emotional value on the car than you should. However, outsiders with no financial stake can help make the decision-making process more rational.
Stick to a Budget
The ultimate way to avoid the sunk cost fallacy is to always consider your budget when making decisions. If spending additional money on a losing proposition causes you to go into debt or miss your saving goals, you’ll see right away that it’s probably not worth it.
If you’re new to budgeting, you can try a simple method like the envelope budgeting system to get started. If you prefer keeping your finances and budgets digital, there are also numerous personal finance apps that make it easy to track your spending and to stick to your goals.
The psychology of money is an interesting concept that also has a significant impact on how we build wealth. The reality is that, as consumers and as human beings, we often make questionable financial decisions because of emotions, not math.
However, the more you learn about behavioral finance theory and cognitive biases, the less likely you are to make poor decisions. The sunk cost fallacy is a prime example of this fact.
It’s something we’ve all done at one point or another, but once you learn to recognize it, you’re far less likely to make poor choices.
Just remember: No one is perfect at managing their money. Work to improve your financial literacy and how you think about money. The next time you incur a sunk cost, you’ll be able to make the right decision based on facts, not feelings.