In my previous piece, I briefly discussed the sunk cost fallacy. In it, I offered some examples of how sunk costs affect human decisions and how some (including myself) overcame what seems like a natural thought process. This is an additional post to highlight some more detailed explanations of sunk cost and how it has become ingrained in our way of thinking.
When I evaluated whether to continue my graduate studies or pursue opportunities more in-line with my long-term interests, I naturally lingered on how my committed time and energy could affect my decision. Fortunately, I attended graduate school on a research assistantship and did not pay for my education.
So, when I eventually made the decision to leave with my Master’s, I had no debt to speak of, nor any money to return for changing to a lesser degree. As a result, my decision was much easier from a sunk cost perspective than many others from the Millennial generation face.
However, had I fallen prey to factoring my sunk costs into my decision, it would have been well within my human nature. After all, I said goodbye to my friends and family, packed my entire life into a U-Haul to move over a 1,000 miles from home, and spent two years of my life going after what I thought I wanted by attending this prestigious program.
I had better be sure of my decision to leave this program early. To understand why people think this way, we have to examine the addictive nature of staying the course and the motivating fear for avoiding a loss.
Thumb on the Scale
The human mind does not measure gains and losses in the same way. For me, I saw immense upside by attending the program compared to the relatively limited downside given the poor shape of the economy at the time (thanks, Great Recession!). How things changed.
Without getting too technical, the human mind has a deep-rooted imbalance between evaluating gains and losses that has evolved over time. Our ancestors were hunter-gatherers who saw self-preservation as imperative because one wrong decision could lead to their demise. Those who chose to focus on survival more than maximizing opportunities lived to see another day and increase the chance of passing along their genes.
I did not see this as my motivation necessarily, because I knew I would be fine at the end. I did, however, think I would be happier if I chose another path.
But this risk-averse decision-making is instinctual because it spread through time and the prospect of losses became a more powerful motivator than the promise of gains, all things being equal. In short, the discomfort suffered from a loss weighs greater on the mind than the pleasure associated with gaining the same amount. In all likelihood, we would not be here were these motivations flipped.
To add an additional wrinkle to this dynamic, when a person faces a decision to change course, quite often the person tends to focus more on what will be lost rather than what potential gains exist. This should not be surprising given the prior explanation, yet it offers a bit more color on explaining this behavior.
In my case, by leaving I saw the future I’d abandon after committing so much of my time and resources as a strong factor in influencing my decision. There’s no doubt that weighed heavily in my mind.
However, the other opportunities I could pursue were more rewarding to me. By choosing to leave early, I prioritized my needs over my wants and hopefully I am rewarded in the long run. But when making the decision, I desperately wanted to avoid having my investment become a loss.
If humans exercised purely rational logic, I would immediately have seen past the sunk cost and unquestionably followed a more rewarding path. Ultimately, a person must be able to offset the pain of loss by the joy of another gain from altering commitments. So, how should a rational human overcome this motivating fear of loss?
Choosing What Really Matters
The test for evaluating sunk costs is simple, yet it may not be easy to pass. The measure boils down to whether the costs outweigh the potential benefits. If the costs loom larger and leave you in a net loss position, abandon ship.
It may feel like the wrong thing to do at the time, but the committed resources and extra costs incurred (satisfaction, time, or even money) should not guide the decision. If the other gains are reasonably probable and are more desirable, the person should chart a different course.
From the previous blog post, Mark Zuckerberg and Bill Gates saw great opportunities that may have passed them by had they continued to attend class. They prioritized reasonably probable gains, cut their losses and ventured out on their own.
We should all take their decisions as a lesson and properly evaluate those commitments in our life which are not in our best interests. Human evolution and sunk costs be damned.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.
Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions, tax reform in 2018, or other useful tax topics. I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.
Please continue to watch the site for more to come and post below with your questions or comments.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.