Are you familiar with the term “sunk cost fallacy”? A behavioral premise that our decisions as humans are influenced by what we have already done. We tend to think that we are rational individuals. We think that we make decisions based on the fact, but this is not completely true. Humans seem are influenced by the time, energy, and money they have put into a project when making decisions. Our past, therefore, tends to predict our future. Sometimes these prior investment prevent us from making good decisions going forward. Let’s go over some examples of when people stay in it despite it not being in their best interest.
Cases in Sunk Cost Fallacy
Case 1: Decisions!
A young person works hard throughout their college years to get into medical school. They kill their social life, opportunities, etc. ensuring they are not a pre-med dropouts. Finally they make it! They are in medical school…but, alas, it is not as fun as they imagined before.
Still, they had worked hard to get there and must continue! It does not matter that it is unbearable. The smell or sight of blood sickens them. Pathophysiology is really not that interesting. They may think, “What is a few more years of school? What’s another $100K in debt?” when they should be thinking “Maybe this is not the right career for me?” So they continue forward. Surely it will be better in residency. Plus think of all the time and effort already invested.
Finally they make it to residency and surprise surprise, it does not get better. In fact, it is worse. Now the hours are longer and the treatment is worse. At least they are making $50K instead of dishing it out. So they hang in there and become an attending. Now they are at least 11 years in (4 in college, 4 in medical school and a 3 year residency). While the pay has improved, the joy has not. This individual just dedicated their 20’s to train for a career they probably knew in year 1 of medical school was wrong.
Now they are stuck because they have medical school debt to pay. Plus, what other job pays so well (in most cases it pays very well). Does that mean the individual should stay the course. I say no. They should pay off their debts and maybe put a little extra cushion in the bank and then pursue something that will make them content. Life only comes around once (unless you believe in reincarnation, then it could be said that this life only comes around once). This is a hard one because medicine pays so well, but if someone is truly unhappy in this field then they should get out.
I give kudos to one friend who left medical school after 2 years and taking Step 1. He is now finishing film school. Despite the debt he accrued and time he lost, he is pursuing a dream, and he is happy. As for me, I like medicine well enough and while I may like other things too, I may keep working for between 10 to 25 more years in this field.
Case 2: Things!
Someone buys an expensive car. It makes them happy! This is what they have dreamed of, but after a few years the joy wears off and now they realize that the monthly payments, insurance, and maintenance are really expensive. That owning this car, which made them super happy previously, keeps them from enjoying other things in their life. They make an active decision to change cars and potentially downgrade. They may feel weird giving it up because of the effort they have put framing their image with that of the car. It makes sense to sell the car but something keeps them from pulling the trigger.
This can apply to homes too. Someone goes and purchases an expensive house. They thought it was a good idea but really are depressed every time they think about the money they are spending on mortgage, taxes, etc. Instead of selling the home and downsizing, they stick with it, purchasing more furniture they don’t want and maintaining a property they don’t need. Their one bad decision leaves them feeling they have to continue forward.
Luckily I have not purchased anything I regretted yet. Part of it is that I don’t buy expensive cars, although I bought an expensive home recently. The home purchase was a much an active decision. It was not something that passively happened to me, and I enjoy it.
Case 3: Insurance policies!
The idea of whole life insurance is probably the best example. Whole life insurance is a policy where a buyer places money into the insurance policy with guaranteed premiums later in life. The problem with whole life insurances is the high fees. For instance, some programs charge one entire year’s investment in fees and a large portion of investment in fees going forward. So, basically there are high up front fees for a return later. While it may be reasonable for some high earners who are otherwise maximizing their retirement accounts, it is not a good idea for most people.
So how does sunk cost fallacy play into the purchase of whole life insurance. Most people are sold whole life insurance. They do not go seeking it out (like term or life insurance). If someone has bought a policy for a year or two, they have already sunk in a substantial portion of money with little return or upside.
They read a financial website or two and realize that maybe whole life insurance was not a smart decision for their future. Still, they have already sunk a lot of money into it and if they continue doing so, then it will be profitable in 10 years. It’s gonna cost them a hell of a lot, but eventually it pays off. Therefore, instead of pulling out of the policy (which is likely the right decision for most individuals), they keep it and continue paying those high fees. Thus their past actions predicts their current decisions instead of just looking at the facts.
I do not own a whole life insurance policy but have a colleague who does. I talked to him about my thoughts regarding negatives of his plan. He told me that maybe he should not have bought it but he is currently 2 years in and has put a lot of money in it. He pays approximately $3000 a month for this policy! That is $36k a year! Nuts! Think about the value of that dollar invested in an index fund earning 6% annually. In 20 years he could have $115,456 for his $36,000 invested today.
Case 4: A financial planner!
There are many people out there who have stayed with their financial planner even though it is costing them thousands of dollars a month. They may have not taken the effort to research their advisors fees and types of returns they are receiving. They don’t worry about these things. In fact, the only reason they picked the advisor is because they came and gave a talk with free lunch in residency once. Now they realize that it is a bad deal, but think of the time and effort it took forming a relationship and worry about leaving them. This is even though they may be able to plan their own financial future more easily and definitely cheaper or find a fee only advisor.
I briefly had a financial planner. She was great, but at the time my finances were and remain very simple. Pay down debt and invest money in 401Ks, IRAs, and 529s. Instead of keeping her, I told her I am doing my own planning going forward.
Case 5: Relationships!
The premise of sunk cost fallacy can occur in friendships too. For instance, someone may spend years becoming friends with someone. Investing a lot of time, but over the year’s people change and one of the friends may become a negative influence. Some people will stick it through, thinking of all the time they had placed into the relationship. They won’t break the ties despite the negative nature of the relationship now. This is a sunk cost fallacy. If someone is truly a negative influence in life, cut them out until they figure their shit out.
I have had friends, particularly early in life (freshman year of college) who seemed great. They were fun, popular, and people that one should be friends with. As the years passed though they became more heavily involved in drugs and more destructive in their own and others lives. It was time to pull the cord on our relationship. I am not saying that you should give up on friends when they are going through hard times. Still as long as you are actively aware of why you are staying in a relationship.
The purpose of this post was to bring attention to the fact that we are human. That the effort, time and money we put into things (items, relationships, etc.) affect our future decisions. This can be detrimental and we need to stay aware of it as a silent influence in our lives.
How has sunk cost fallacy messed with you? Are you being hesitant to pull the trigger on something because of prior investment to it?