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Why we are compelled to throw good money after bad – psychology of money part 3

March 28, 2019  |  #Money Management

Cost avoidance is real. We are built to want to make meaning of the past. How does that impact our decisions with money?

In Psychological terms, ‘avoidance’ is a coping mechanism we humans deploy when we are trying to avoid or escape particular thoughts or feelings. It’s a defence mechanism we attempt to save ourselves from experiencing unwanted stress. The result, however, often leads to greater anxiety, reduced confidence and worsening problems. How does this relate to money?

Great question!

 

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‘Throwing good money after bad’

We’ve all heard the saying ‘throwing good money after bad’, but what is behind that? We know that there are many things at play when it comes to our behaviour with money and the discrepancy between what we say we want and what we do. The sunk cost effect is at play when we have a greater tendency to continue with something after an investment in money, effort or time has been made. We just don’t like to feel like we have wasted one of our valuable personal resources!

 

cost avoidance - inline 1

 

When we have already paid for something, we feel compelled to stick with it or use it. Take for example a scenario where you have accidentally bought tickets to two events on the same day. One costs $50 and the other $100, and you know you will have more fun at the $50 event. Research shows that on average, more than half of us will choose to attend a more expensive event. The sunk cost matters more to us than our enjoyment.

 

Humans vs. Economics

The ticket example is a classic example of where human intervention meddles with economic theory. Rationally, it makes sense to base our decisions about the future on the information we have at hand now, irrespective of sunk cost. If the pain of ‘spending’ has already occurred, we shouldn’t consider it when making decisions. Take this for example:

“A man wins a contest sponsored by a local radio station. He is given a free ticket to a football game. Since he does not want to go alone, he persuades a friend to buy a ticket and go with him. As they prepare to go to the game, a terrible blizzard begins. The contest winner peers out his window over the arctic scene and announces that he is not going because the pain of enduring the snowstorm would be greater than the enjoyment he would derive from watching the game. However, his friend protests, “I don’t want to waste the twelve dollars I paid for the ticket! I want to go!” The friend who purchased the ticket is not behaving rationally according to traditional economic theory. Only incremental costs should influence decisions, not sunk costs. If the agony of sitting in a blinding snowstorm for 3 hours is greater than the enjoyment one would derive from trying to see the game, then one should not go. The $12 has been paid whether one goes or not. It is a sunk cost. It should in no way influence the decision to go. But who among us is so rational?”

 

cost avoidance - inline 2

 

Sunk cost bias plays out in investment decisions as well. For example, let’s say you have bought into a particular stock and it starts to decline. We have a hard time letting go or selling, even when the information at hand tells us we are on a downward slide because we factor in the sunk cost of that loss. Rationally we should be deciding to hold or sell based on the future likelihood of performance. But the sunk cost of losses and time can keep us holding.

By hanging on, we avoid the realisation of cost, but at what expense?

 

How to avoid sunk cost

The best way to ensure you are not your own worst enemy when it comes to money is to talk about it, share your situation and ideas or decisions with an objective and qualified third party who can road test the facts. There are many psychological impacts playing between your aspirations and behaviours, but you can avoid the pitfalls.

 

What’s your plan? Get in touch with our financial advisers.

What you need to know

This information is provided by Invest Blue Pty Ltd (ABN 91 100 874 744). The information contained in this article is of general nature only and does not take into account the objectives, financial situation or needs of any particular person. Therefore, before making any decision, you should consider the appropriateness of the advice with regards to those matters and seek personal financial, tax and/or legal advice prior to acting on this information. Read our Financial Services Guide for information about our services, including the fees and other benefits that AMP companies and their representatives may receive in relations to products and services provided to you.


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