To be successful in personal finance, you must master both the personal and financial sides of the equation.
The financial side is simple: earn more than you spend, invest the difference, and avoid taking unaffordable risks.
Anyone can learn the basics of finance with the abundance of free knowledge on the internet.
The personal side is much harder. Money can be emotional, especially when you feel like it’s being “lost” or “wasted.”
Fighting against behavioral mistakes and learning to control your emotions from getting in the way of making good financial decisions is easier said than done.
A common behavioral mistake is the “sunk cost fallacy,” or our tendency to let money, time, and energy already spent (and can’t get back) influence our future decision-making.
Once you learn about the sunk cost fallacy you’ll realize it happens all the time to everyone around you.
Get good at spotting sunk costs in your life so you can make better financial and life decisions.
Spot Those Sunk Costs
The definition of a “sunk cost” is money, time, or effort that you’ve spent in the past and cannot get back.
In terms of money, sunk costs could be a non-refundable plane ticket for a trip you no longer want to go on or an investment in a company that has gone south.
In terms of time and effort, sunk costs could be a career you’ve spent years building but no longer enjoy or a relationship that is no longer working out.
Whenever you’re faced with a situation where you can’t get back the money, time, and effort you’ve already put in, you’re dealing with a sunk cost and have 2 options:
- Let it go. Take the loss, learn from your mistakes, and move on
- Continuing pouring your resources (money, time, effort) into the situation
In a perfect world, we would decide which option to take based on how confident we feel things will improve and if sticking it out will give us a return down the road. If the juice is worth the squeeze, so to speak.
The money, time, and effort we’ve already invested should have no impact on our expectations for the future because regardless of which choice we make, we can’t get them back anyway!
In the real world, this is rarely the case. Think of what actually happens in the previous examples:
- People will still go on the trip, causing them to spend even more time and money, because they don’t want to “waste” the ticket
- People will keep an investment that has gone south, even at the risk of losing what’s left of their money, because selling would mean that the loss is now real
- People stay in jobs or relationships they no longer want to be in because they don’t want to “lose” the time and effort they’ve invested into them
While it sucks when things don’t turn out the way you want, not knowing when to cut your losses will cause you to waste more time, more money, and more effort than if you just let them go.
What Are You Giving Up?
The best way I’ve learned to let go of my sunk costs is to think logically in terms of opportunity cost when making decisions.
There is an opportunity cost to every decision because your life resources are limited.
You have limited time, limited money, and limited energy. The choice to use these life resources on one thing will cause you to miss out on the chance to use them on something else that could give you a better return.
Continuing to pour money, time, and effort into a situation you don’t think will improve is just taking away valuable resources from other areas of your life.
Practice thinking in terms of opportunity costs.
What are you giving up by continuing down your current path? Are there other things that could give you a better return on your time, money, or effort?
Sometimes the best decision is to cut your loss, learn from your mistake, and move on to something better.
Other times it’s worth sticking out a situation because you expect things to improve and pay off in the future.
Both options are completely fine. But you should understand the opportunity cost of your decision and ask yourself if sunk cost fallacy is affecting which route you take.
Once you get good at spotting sunk costs and thinking in terms of opportunity cost, you will reap the rewards in your financial and personal life from making better decisions.