It’s Eddie, and it’s more interesting than last week.
Last week I gave what was likely a boring example of a solution to sunk cost fallacy using the example of developing an oil & gas property. This was based upon a previous post explaining the concept of sunk cost fallacies. This week’s post gives more individual solutions to sunk cost fallacies and how to avoid them.
Avoid careers with defined-benefit pensions – oft lauded by uneducated personal finance bloggers, jobs with DB pensions are rife with the sunk cost fallacy bias. DB pensions are sometimes thought of as ‘golden handcuffs’ by PF bloggers, but they don’t even get the golden part correct (in my opinion, a prudent person who has career flexibility through a DC pension or contract work will develop more skills and get more economic benefits through progressive salary increases than a similar employee with a sole employer with a DB pension). An employee with a company or in a career with DB pension scheme is susceptible to a weighty decision if their career prospects or job satisfaction decreases considerably: should I stay with my company in a dreadful job for X years and wait for my pension or do I leave for greener pastures? Avoid doing this to yourself and go for a DC pension or none at all.
On a personal note, I left the army and its “gold-plated” pension after 10 years of service. Since I left the military a year ago, I’ve more than tripled my take-home pay but have no pension. However, my decision was a poor one because I don’t have a DB pension (queue the sarcasm).
Fail Early and Fail Often – this is an oft-quoted maxim of entrepreneurs and a principle of the Lean Start-up methodology. The basic principle is that it is better to validate a business idea with a minimum viable product early with low sunk costs rather than investing lots of time and money into a product that nobody may want. While I am not completely sold on the entire Lean methodology (aka fad) for several reasons, there is inherent logic to this principle.
This notion can be readily applied to education. Take for example a person who, at the beginning of their college career, is adamant about becoming a lawyer. To get the best GPA and make their application more attractive to law schools, they take “easy” undergraduate courses in a degree that has lower job prospects but increases their chances of getting into a JD program. However, if they discover in first year law school that they in fact despise it, they are faced with a terrible decision: continue into a career that they will likely despise or take another program that will get them a good job that they will enjoy. The magnitude of this choice and the effects of sunk cost fallacy would have been drastically reduced if they would have obtained a relevant degree with promising career prospects. Every step in an educational or professional endeavour should be viable in isolation. Also, test your assumptions as rigorously as possible before you begin.
Continue to learn about finance, not personal finance – personal finance, as a subject, quite one-dimensional and boring the way it is presented on blogs and in books. One can only write so much about simplistic subjects such as loyalty programs, credit cards, index investing, emergency funds, RRSPs etc. My complaints aside, a prudent disciple of personal finance – and life strategy – should study some topics in finance. Relating to the subject matter in question, one should know or have familiarity with the following:
The difference between fixed and variable costs
Operating leverage (not financial leverage)
The effects of fixed and variable costs on the payback period, operating margin, and profitability on increasing and decreasing levels of output
The risks, benefits, and costs associated with choices with high fixed or high variable costs
For your knowledge, a higher fixed cost business has higher operating leverage, greater losses at lower output and greater profits at higher output, a higher payback period, and generally higher risks compared to a high variable cost business.