I periodically find myself hesitant to make sound financial decisions because of money that I’ve already spent. Behavioral economists call this tendency the sunk cost fallacy. But your future money decision making should not be influenced by thoughts of past expenditures that cannot be recovered.
What exactly is the sunk cost fallacy? To explain, I will use a common example. Assume that you previously purchased a ticket to an outdoor concert or sporting event. The morning of the event you learn that it will rain or be uncomfortably hot or cold at the event venue. You really won't enjoy the event because of the bad weather. But that ticket cost you a lot of money. Should that previous expenditure cause you to suffer through an event that you won't enjoy? Or, despite having paid the price of the ticket, should you use your time to do something more fun?
The irrational decision makers are those who think about the ticket cost already incurred. They will force themselves to attend the event because it would be wasteful not to. That makes no sense. Whether you attend or not, the ticket cost has already been incurred and cannot be recovered. In this case, your future behavior should be guided by what is best for you now and not dictated by money already spent.
Here are three ways the sunk cost fallacy could negatively affect your retirement planning
1. Clinging to poor investments. Say you purchase a stock or mutual fund and then the value declines. All indications are that the investment was a mistake and should be sold. Yet you hold on, hoping against reality that the value will return. You think that you will waste your money by selling when the investment value is down. This is the question you should be asking instead: Would I buy that investment today? If the answer is no, sell it and stop thinking about money already spent and gone. Invest the remaining value in something better.
2. Keeping useless stuff. Preparing for retirement is a time to shed yourself of stuff you don’t need. Think about the unworn clothes in your closet, the TV in the spare room you don't watch, and the athletic gear in the garage that you are too old to use. The decisions you make on discarding or giving away something should be based on whatever pleasure keeping that object will give you now and in the future. The money the stuff cost you is irrelevant because you can’t get the money back by keeping the stuff around. Most of the stuff piled high in your attic, closet, basement, or garage is unlikely to give you pleasure in the future. It will only get in your way when you downsize in retirement.
3. Hanging on to a losing business. Sadly, a high percentage of small businesses are unprofitable and eventually fail. Some small business owners incur significant personal debt in a desperate attempt to save their initial investment. They spend their savings or borrow to turn around a business that is never going to make money. When this happens to someone close to retirement the results can be devastating. Do not throw good money away to save a losing business. That good money could be your retirement money.
Acting irrationally in accordance with the sunk cost fallacy is human. But if you can resist doing it your retirement investments will benefit.
Mark Patterson is an engineer, patent attorney, baby boomer, and author of The Failsafe Retirement System. He blogs on matters of personal finance and retirement planning at Tough Money Love and Go To Retirement.