It’s the day after Hump Day, which totally doesn’t mean what I thought it did. So while I’m pondering that, you get Eddie.
One topic that I would like to explore more thoroughly is that of decision-making. The psychology of cognitive biases and their implications are far important to personal finance than any book or post on RRSPs or index investing.
A sunk cost is an expense that cannot be recovered; it is money already spent. Conversely, a prospective cost is a future cost or represents monies that have not yet been spent. Prudent fiscal management states that only prospective benefits and costs should be factored into economic decisions and sunk costs should be ignored. Stated another way, money spent in the past have no bearing on future decisions. By taking previous costs into account, a person is committing sunk cost fallacy.
Sunk cost fallacy is present in the oil and gas industry. Management must be careful of this cognitive bias to make the best decisions. For example, a project can be typically broken down into two main phases:
Design – the site is studied, the economics of the project are justified, and designs are produced; and,
Construction – the project is built as per the design, the facility is commissioned, and operations begin. Construction costs make up the majority of the project’s total cost.
Say for instance that when construction began on the project, the price of oil experiences a steep drop or there are previously undiscovered environmental issues that completely negate the benefits of the project. If a manger declares that the project will continue on the logic that they need to get something out of their investment in design and construction costs, then they are throwing good money after bad and are a victim of sunk cost fallacy. The project should be valuated on the costs and benefits at the present and not based on previous and sunk costs.
The issue of sunk cost fallacies is explored by Rolf Dobelli in his brilliant book, The Art of Thinking Clearly. He cites two prominent examples of sunk cost fallacy: the Concorde and the Vietnam War. The Concorde was a supersonic aircraft that, while having a very interesting design, was commercially untenable. Despite this obvious and serious flaw, the British and French governments poured additional money into the project to “save face”. Similarly, the US government continued to pour lives, treasure, and resources into the war in Vietnam with little hope of winning in an attempt to justify their previous decisions and losses.
Sunk cost fallacy is prevalent in everyday or routine decisions as well. The most oft-cited is that of holding an investment after a steep decline in value and below the acquisition price. If the holder is pessimistic about the investment’s prospects and is holding it with the slim hope of selling it at near its acquisition price, then keeping it would be sunk cost fallacy. The acquisition price should have no bearing on whether the investor should keep it or not (other than its tax implications).
Other examples could include:
If one assumes that defeating terror groups in the Middle East is impossible, the recent decision to expand the war against ISIS/ISIL would be sunk cost fallacy if (US) politicians state that the Iraq War (2003-2011) would be for nothing if they did not take action
Staying in a job with a defined-benefit pension if you believe the work is terrible or career prospects low. Even though you have some time vested with the pension, staying because you have put in X number of years is sunk cost fallacy
Keeping a lemon of a car because of all of the money you have invested into repairs
In researching this article, I came across an excellent reference for all of you sports enthusiasts. The article talks about the decisions facing the Washington Redskins and Robert Griffin III. Enjoy.
Next week we’ll explore solutions to sunk cost fallacy. Stay tuned.