As an individual with a degree in Psychology, I have learned how cognitive biases can impact your life in many ways – including your personal finances. One of these cognitive biases is called the sunk cost fallacy, and it can have a detrimental effect on your financial decisions. This article covers the sunk cost fallacy, it’s impact on your financial decisions, and most importantly, how to avoid falling into its trap and the hidden costs that comes with it. Understanding and overcoming this cognitive bias can significantly contribute to your journey towards financial freedom.
The sunk cost fallacy, rooted in psychology, is a cognitive bias that leads us to follow through on something that we have invested time, money, or effort into – even when it doesn’t make sense to keep going! It occurs when we consider the resources we have already expended and factor them into our decision-making process, even when they are no longer recoverable or relevant. This can be problematic because the decision to continue is based off of emotional thinking, without taking into account if current costs outweigh the benefits, which leads to suboptimal outcomes.
In the realm of personal finance, the sunk cost fallacy can be a significant roadblock to achieving financial independence – especially when it comes to investing. Here are a few common scenarios where this fallacy comes into play:
Holding onto Underperforming Investments: You might find yourself reluctant to sell an investment that has consistently underperformed. The reason? You’ve already put a substantial amount of money into it, and parting ways feels like admitting failure. However, holding onto such investments could prevent you from reallocating your funds to better opportunities, ultimately hindering your long-term financial growth. Simply, holding onto an investment that you know is a bad one – will not guarantee that it will appreciate over time and even if it does, the money that was waiting to appreciate could have earned more if invested in a wiser fund/stock.
Continuing Education for Career Advancement: Imagine investing time and money in pursuing a degree or professional certification, only to realize that it no longer aligns with your career goals. Despite this realization, many individuals are hesitant to change course because they feel obligated to stick with their initial choice because of all of the time they have spent working towards it thus far. As a result, they miss out on exploring other potentially more rewarding paths that align with their future goals.
Sticking with Costly Subscriptions or Memberships: Have you ever found yourself holding onto a gym membership or subscription service you rarely use, simply because you’ve already paid for it? This is a classic example of the sunk cost fallacy. Continuing to pay for something you don’t fully utilize is a drain on your finances and an opportunity cost for investing in more meaningful areas of your life.
Recognize the Fallacy: Awareness is the first step towards avoiding the sunk cost fallacy. Understand that the resources you’ve already invested are gone and cannot be gained back in most cases. The only relevant factors for decision-making should be the current and future benefits and costs.
Reframe Your Perspective: Instead of dwelling on past investments, focus on the potential future outcomes. Consider the opportunity costs associated with holding onto an underperforming investment or sticking with an unfulfilling situation.
Evaluate Objectively: Take a step back and assess your options without emotional attachment. Consider the current value of the investment or decision and compare it with alternative opportunities. Make decisions based on the potential for future returns rather than past investments. It helps to think of your situation as if you were giving advice to a friend.
Seek External Input: Consulting with unbiased individuals, such as financial advisors, mentors, or friends can provide valuable perspectives. They can help you evaluate your options objectively and avoid falling into the sunk cost fallacy.
The sunk cost fallacy can have a significant impact on your journey to financial independence. By understanding its influence and learning how to overcome it, you can make more rational decisions aligned with your long-term financial goals. Investments of time, money and effort from the past can be mistakes that no longer align with your future goals; Remember, what matters most is the future value and potential returns, not the ‘sunk costs’ that cannot be recovered. Embracing the current costs and benefits and seeing how they align with your financial aspirations is essential in taking steps to avoid the sunk cost fallacy.
