The Sunk Cost Effect
There are many many many many many books that teach you how to make money, but almost none that show you how to avoid losing your money. I personally had never really thought about this, at least not until I read the book What I Learned Losing A Million Dollars (an amazing book that I strongly recommend). Like everyone else, I was more concerned about making money rather than about how not to lose it. But as Jim explains it, there are many ways to successful make money but few to lose it all. You can invest in opposite strategies and still make money! The key to long term wealth is to understand the psychological forces that induce us to lose our money, even through our best efforts.
The book What I Learned Losing A Million Dollars starts off with Jim’s personal story of how he quickly climbed up the success ladder and then in a matter of a few months lost his entire wealth. What’s most interesting about the book is that what happened to him could happen to anyone. But the scariest part is how fast it can happen. It’s not that he did stupid things or spent wildly, it’s that he got caught up in a psychological trap. One that we all fall prey to from time to time, just on smaller scales.
Once it was all over for Jim, he went on a quest to find what the best investors did. What he found is that there was no consistency, they were all over the place. Many of them contradicted themselves and still succeeded. This lead him to question how this was possible, after all in most cases when two people use the opposite strategy one person has to come out ahead at the expense of the other. That’s how the markets work.
What he found out was that this wasn’t necessarily true. What happens is that successful investors know when to stop, when to drop an investment. Investors using opposite strategies aren’t always in the market, they’re in the markets at different times. They know when to wait on the sidelines until the markets favor their strategy. They don’t fall prey to as many psychological traps as ordinary people do. That is the only common thread he was able to find for highly successful investors!
And today we’re going to discuss one of those very common traps. It’s the effect of looking at your previous costs in determining whether or not to go forward today, otherwise known as the Sunk Cost Effect.
To give you a common example unrelated to investing, just to show how prevalent and strong this effect is, let’s take the example of car ownership. Let’s assume you own a car that’s a few years old (still pretty new) and you’ve just spent $2000 in repairs on it a couple of months ago. Suddenly this week it starts misbehaving, you bring it to the garage, and find out you need to spend another $1000, $2000, or even say $4000 on it. What do you do?
The best answer is to look at the value of the car TODAY and determine if it’s worth it TODAY. However, and this is where we almost all fall prey to the sunk cost effect, is that we also look at the fact that we just spent $2000 a couple of months ago. We’ve already spent that much money on it, so we might as well go forward with the new repairs. We don’t want to lose that $2000 in repairs from a couple of months ago. We may even rationalize that what we fixed a couple of months ago won’t break down again for some time so the car is better for it. And that’s a big problem!
What happens now if in another month we get another bill for another $2000? Well you have to get the repairs, after all you just spent $3000-$5000 in the last few months. And then what happens in another couple of months if it repeats. Oh my god!! We just spent $5000-$9000, there’s no way we want to lose all that money and/or effort. And so the vicious cycle has started and we start to lose more and more money just because we didn’t want to lose that initial $2000!! Trying to avoid losing that initial $2000 repair bill has now cost us around $10,000, and it’s only going to get worse! If the car is a lemon, how long will it take for us to give up? If you think it was hard at $2000, imagine now at $10,000! The more you lose, the harder it gets to pull out!
And it’s not just with cars, it can happen with just about anything. It can happen with your job. You may have already committed 3, 5, 10, 20 years to this job. You may hate it, it may be paid below market rates, and so on. But since you’ve already committed so much to it, you’re probably less and less likely to quit with time. This is why people get caught up in jobs they don’t like for years and years.
With investing, in real estate it could be you’ve already spent so much money renovating a property that you now have to wait to sell it until the market recoups, losing money each month for years and years, possibly losing everything through bankruptcy to avoid losing that $10,000 you initial spent on renovations. In the stock market, it’s a stock you bought at too high a price that you’ll now hold onto until it goes back to at least it’s original price. The list goes on and on.
The reality is that we should always look at whether something is worth it as of today. Period. It doesn’t matter how much time or money we spent on it in the past, we need to look at how much it’s worth today. If you can do that, you will save yourself a lot of trouble and money!
And that’s what smart investors do. They evaluate an investment in terms of what it’s worth today, they don’t look at how much they’ve already invested. In other words, you should always ask yourself: If I wasn’t already committed would I invest into this today? If the answer is no, then you need to seriously consider getting out of your investment before you fall prey to this trap, otherwise it will be that much harder as your position gets worse!
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How to Get a Pay Cut AND Be Happy About It
Let me start by asking which you’d prefer:
- A 10% raise?
- A 3% raise?
If you’re like almost everyone, the answer is hands down #1. But let me re-phrase the question a bit. Which would you prefer?
- A 10% raise in 1980?
- A 3% raise in 2009?
Is your answer still the same? I bet you think it’s a trick question because I added a year to the options. You’re right, it IS a trick question! The years 1980 and 2009 are special. Can you guess why? 1980 is very well known for having a very high inflation rate whereas 2009 is known for being a deflationary year (a year where the inflation rate is negative). In 1980 the inflation rate was 13.5% whereas in 2009 it was -0.4%. Having brought this new information to light, is your answer still the same?
In other words, which do you prefer:
- 10% raise at 13.5% inflation in 1980 = a real -3.5% raise in terms of purchasing power
- 3% raise at -0.4% inflation in 2009 = a real 3.4% raise!
Looking at the numbers adjusted for inflation, option #2 is now by far the best economical choice, beating option #1 by almost 7%!! Option #1 is actually a pay cut!
Now here’s the kicker, although most people realize option #2 is the best economically, the majority of us FEEL that the person in option #1 is HAPPIER with their raise than the person in option #2. Notice here I said feel happier, NOT that they were financially ahead! Although we’re able to differentiate between the two, most people still believe they would feel happier with option #1!!
What’s more, this same research paper (Money Illusion) also discovered that people believe the person in option #2 was more likely to leave their job. Basically, as William Poundstone summarized in his book Priceless, the overall theme of the paper is:
“$$$ = happiness = actual dollars NOT ADJUSTED FOR INFLATION”.
So how do you get a pay cut and be happy about it? Get a raise, but have that raise be less than the rate of inflation.
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As If We Weren’t In Enough Trouble Already?
We all know the real estate market is in a mess right now, and most of it is really our fault. Too many people took on mortgages they never should have. But it’s not just the borrowers that are guilty, the lenders need to take their share of the blame. Obviously everyone should know when they’re over-extending ourselves, but in obvious situations many lenders still encouraged people to get mortgages. They often helped them get financing through more creative ways, such as loan/mortgage applications that didn’t require any proof of employment, interest only payments, 105% financing, and so on. I won’t even mention mortgages that required high and consistent capital appreciation just to be sustainable.
As part of this mess, many different sales techniques were used. A very common technique was focusing on how much mortgage you CAN afford per month (not how much you SHOULD afford per month). What this means is that instead of looking at the total purchase price, you focus on the monthly payments. By doing this, especially when interest rates are incredibly low, you end up buying properties that in any normal time is well above what you can afford. Which also means that when interest rates go back up, which they will, you’re in a lot of trouble!
Again, the benefit of this selling technique is that you can take the focus away from the real price and look at what you can spend each month. This gives the seller a lot of leeway in the price (not to mention it helps increase commissions). As an example, adding $2000-$5000 on a $500,000 mortgage amortized over 30 years (at our current historically low interest rates) barely changes the monthly total ($9/month and $22/month respectively)! Even adding $20,000 isn’t that big a deal. At 3.5%, $20,000 barely adds $90/month more. $90/month more on a $2500/month mortgage is not a big difference.
But, getting back to the reason for this post, is that lenders have now come up with a new method of rationalizing why you should purchase overpriced properties, or at least a method that I haven’t personally seen yet. Here’s the exert from Tales From the Real Estate Wars:
“Now’s the time to move up to a larger house and eradicate any loss on your present house! How, you say? Come a little closer and I’ll explain: If you bought a house for $350,000 and it is now worth only $280,000 (20% less), you have only “lost” $70,000 if you sit still and do nothing. But if you buy that really big house in the nicer community that used to be worth $550,000 and is now also 20% lower, the moment you close on that house at $440,000, you’ve gained $40,000 ($110,000-70,000). And hey, that’s before you get the $6,500 tax credit! Plus, have you seen how low the interest rates are?”
It’s really perverse logic, but at the same time I can see how people can fall prey to it. They’re focusing on people’s loss aversion fears which is a very strong emotion!
Do you see the flaw in the logic?
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Why I Have So Many Printers
I hate to admit it, but I have more printers than I have computers. Why is that? Is it because I love printers? Not at all. It’s because it’s economically cheaper to buy a new printer almost every time I run out of ink.
For example, today on Amazon I can buy the Canon iP3600 Inkjet Photo Printer for $43.08. Don’t be fooled by the sale price, just do an Amazon search for printers in the $25-$50 range and you’ll find lots of printers in that price range. Many are cheaper than this Canon printer, I just picked it because the discount wasn’t as heavy as some of the other models.
Now if we look at the price of ink cartridge to replace it, what they call the value pack, to replace all the colors including black, it comes to $41.05. Yes, it’s actually cheaper to buy a new printer than to buy ink. And I get a new printer!!
I understand that ink is where printer manufacturers make their profits, and that more often than not the printers themselves are loss leaders, but this is a bit ridiculous. Is it just this one case?
Epson has a WorkForce 30 Color Printer selling for $59.99. To replace the ink requires a $16.49 purchase for black ink and a $32.99 purchase for color ink. Combined, that’s $49.48, just $10 shy of a brand new printer!
And it’s not just Canon and Epson that do this, pretty much all printer manufacturers are in the same boat. Too often the price of replacing the ink is equal to or greater than the price of a new printer.
I do understand that the ink packs they give you with new printers aren’t the same size as replacements, but most people don’t generally think about this when they’re in the store itself making the purchasing decision. What we’re thinking is in the first case I get a free printer. In the second, for $10 more we get a whole new printer!
With this in mind, it’s easy to understand why people such as myself have too many printers.
And don’t get me started on how shoddy most printers are built these days. How many printers have you had that lasted more than a year or two before they stopped working?
PS: The prices on Amazon have already changed from when I initially wrote this post.
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