Most of us are prone to systematic errors in our decisions, and I would like to review two of them that seem to come up frequently. (For more, see here and here.)
The first issue is sunk costs. A sunk cost is something that is already spent or some action already taken. The logical error comes when we consider these costs when making decisions about the future. An example may help. Suppose you pay $100 for a ticket to a concert and then lose the ticket. Should you purchase another $100 ticket? Yes. Attending the concert was worth $100 when the original decision was made, and assuming you have $100 more to spend, it should be worth it still. But many people look at the $100 sunk cost (on the first ticket) and phrase the question, “Do I want to spend $200 to go to the concert?” Similarly, if for some reason on the day of the concert you really didn’t want to go (maybe the weather is terrible and you are tired), would you go anyway because of how much the ticket cost? Many people would. However, if they had been given a free ticket (or it was a free concert) they wouldn’t go. We shouldn’t proceed on paths that are no longer optimal because of the consideration of these irrelevant (at this point) costs. Some examples:
- I can’t change careers – I have too much invested in this one.
- We can’t abandon construction on our home – we have too much invested.
- I can’t sell that stock – I paid double what it’s worth now.
It may make sense to stick with your career, house, investments, etc. but the decision should ignore costs to that point. We should look at it as:
- All things considered, will changing careers make me happier than sticking with my current one?
- Will the future value of the home to me be worth more than the estimated future construction costs plus what I could get for selling right now?
- If I had cash instead of the stock, would I pay the current price of the stock to own it?
In short, sunk costs are irrelevant to the decision at hand.
The second issue I want to address is confusing good (bad) decisions with good (bad) outcomes. Not infrequently, poor decisions have good outcomes and poor decisions have good outcomes. For example, suppose someone offers you $100,000 to play a single round of Russian Roulette. If you decide to do so, and pull the trigger on an empty cylinder, you still made a very poor decision even though the outcome was good. Similarly, purchasing appropriate life insurance is a good decision even if you don’t end up dying while the policy is in force. Investing your retirement savings in lottery tickets is a poor decision even if you happen to win. Diversifying a portfolio is the correct decision even if your neighbor didn’t diversify and made a lot of money on a speculative stock.
In short, while it is profoundly counterintuitive, previous investments shouldn’t affect decisions and the quality of the decision is not determined by the outcome!