Suppose you open up a restaurant. It's in a good location, your food is good, and the prices are reasonable, so you go into business. However, after being in business for 3 years, you still haven't made back the money you put in. In fact, you've been losing money for the past several months. What do you do?
If you decide to keep on putting in resources into the business, believing that you need to keep going because you've spent so much on the restaurant already, you have fallen victim to a thought process many people term as the sunk cost fallacy.
In simple terms, a sunk cost is a cost one incurs that cannot be recovered. Any expenses we've already made counts as sunk cost and a fallacy simply means mistaken belief.
So what is the sunk cost fallacy? It is when one believes that a decision or action is justifiable because of how much cost have already been put into it.
Falling into the trap of the sunk cost fallacy can lead you to make bad financial decisions, condemn you to more debt, and influence you to hold onto bad investments for longer than is good for you.
Knowing to quit when you're ahead is important. Here are some of our tips on how to avoid falling into the trap of the sunk cost fallacy.
Avoid "Going with it" Just Because a Purchase Has Been Made
Sometimes we may choose to pre-order an item, back a product on a crowdfunding site, or purchase tickets in advance in order to save money.
It's true, certain items can be bought for cheaper depending on how early you buy them. However, sometimes you can get caught in a bad bargain just because you don't want to 'waste' whatever has been put into the purchase - be it time, effort or money.
Say you pre-ordered a book that you thought would be exciting with a payment of 30% the purchase price but upon it's release you find reviews to be not so great. You're now not sure you want this book but instead of asking to cancel, you think - "oh well, might as well just go with it since I already paid the 30% and went through all the trouble of making a pre-order".
Instead of taking the less hassled way; how about checking with the seller if you can cancel the pre-order? If you can't, then you can't but most good businesses will be more than happy to at least afford you store credit.
Sometimes, a little more effort is better than shelling out more cash needlessly.
Be Realistic With Passion Projects
In the example given above, a restaurant is not doing well and the owner is losing a lot of money. Continuing to borrow cash and refinancing the place might seem like obvious mistakes.
However, we all have the potential of making the exact mistakes if we well and truly believe in what we're selling.
Suppose we learn that the restaurant owner is actually taking over from a family business and seeks to keep the family tradition of selling chap fan alive. It's not unreasonable to assume this person will bleed themselves dry financially to keep the restaurant afloat.
As noble as those intentions are, they will lead to financial ruin should the desire to succeed not be tempered by realistic expectations.
Running the numbers and looking at the figures objectively is an exercise we should do with all our investments. It's important to do so regularly so we don't get swayed into thinking our sinking losses can somehow be made up by continuing to pour funds into the same coffers.
It's a nice motivational speech to believe that "everyone can achieve their dreams with self business" but reality comes hard and fast when the spare change you're making on your 'business' can't even pay for the food on your table.
Cutting losses is hard, but it's a vital skill to develop in order to ensure the health of our financial investments.
Don't Be Swayed By the Faulty Opinions of Others
The problem with a faulty thought process that is textbook famous is that well, it's famous because it's more than you who many fall prey to it. Perhaps you don't believe this method of thinking at all but you are surrounded by well-meaning people who do (or even the less well-meaning).
For example, say you want to stop your self-business because you realise there is really no money coming in but well-meaning friends and relatives tell you otherwise.
"How can you give up now after all the money you've spent?" or "You've put so much time and effort into this; now you want to give up?"
How often have we heard this and how often do we give in?
The very problematic basis of the sunk cost fallacy is that it is a decision made on a factor that has really nothing to do with the problem at hand. How much you have invested has no real correlation to how much you will make in future or how successful your endevours will be.
Nobody likes to admit that the money they spent is gone and there's no way of getting it back. But recognising that a sunk cost can't be recovered is one of the best ways to stop ourselves from losing even more money.
Do you have a story of that one time you fallen victim to the sunk cost fallacy? Did you get out of it? Perhaps you have some tips of your own? Share them with us in the comments section.