In a previous post, I explained one of my favourite concepts in economics- diminishing marginal utility. Today I want to go over another concept I like from the world of economics, sunk costs.
What does sunk cost mean?
In simple terms, a sunk cost is “a cost that has already been incurred and thus cannot be recovered” (Thanks again, Investopedia). The fact that it can not be recovered is the interesting part, that’s why we ignore sunk costs in financial models.
Example number 1 of sunk costs
Lazy FI restaurant owner just renovated his (rented) restaurant for £500,000.
He now faces 2 options:
- Open the restaurant as usual.
His revenue is projected to be roughly £30,000 a month.
his monthly expenses will be:
£12,000 ingerdients and drinks
£8,000 wages to staff
Total monthly costs: £32,000
- Close the restaurant, cut his losses and look for his next adventure.
What would you do?
In essence, Lazy FI restaurant owner can keep the restaurant open and lose £2,000 a month or close the restaurant and not lose that money. Easy decision, right? in a perfectly rational world- yes, he should close the restaurant ASAP. But what about the fact that he just invested £500,000 into the renovation?
As this money is irrecoverable and was already spent, he will not get it back in either scenario. For that reason, there’s no point in considering it in the decision-making process. Lazy FI restaurant owner will be £2,000 worse off for every month he delays the decision to close the restaurant and move one.
Example number 2 of sunk costs
Sunk costs are not always monetary, sometimes time can be a sunk cost.
In my job, my team is currently looking at automating some processes (Lazy utopia!). My boss said to us something that I found really inspiring. She said, “When you’re thinking of how to do things, ignore how we currently do things, think how you would do it if we were starting from scratch”.
What an amazing approach! I can’t tell you how many hours went into the Excel models she now wants us to (potentially) ignore. If we keep using them, will we get the time back? no. Should we keep using them (although we can do things better) just because of the time it took to create them? of course not.
We need to make a decision that will result in the best future outcome. In our case, that decision is to change our ways of working.
I think it’s also an important question to ask yourself before making a decision: “Ignore what happened so far, what would you do if you were starting from scratch?”
Example number 3 of sunk costs
Have you ever sat through a really bad movie because you’ve already gone out and paid for the ticket? Congratulations, the sunk costs fallacy got the better of you.
Don’t feel bad, I have done this too. It was a bad decision, but I still made it.
From a cost perspective, it doesn’t matter if you leave halfway through the movie or stay until the end, in both scenarios you won’t get your ticket money back or the time it took you to get to the cinema. What can you change? you can save yourself from an hour of the same bad movie (I am specifically thinking of the movie “you were never really here” by the way).
When emotions take over
Decisions that we make should (ideally, in a perfectly rational world) ignore sunk costs. However, in our real, emotion-full world, we sometimes find it hard to ignore sunk costs. The acceptance of a past loss is not easy.
That’s why Lazy FI restaurant owner may keep the restaurant open until he goes bankrupt. It’s why our team haven’t made changes for a while. It’s also why I can tell you that the second half of “You were never really here” (I wish I never was) is no better than the first half.
What has sunk costs got to do with FI?
FI is achieved by a series of good decisions. These decisions will, ideally, lead you to a high (this is subjective of course) savings rate. If these savings are invested wisely, you will eventually achieve FI.
Once you recognise the concept of sunk costs, you can make better decisions in every aspect of your life, including those that affect your FI journey but not only.
In essence, you need to know that the fact that you already spent time or money on something, shouldn’t make a difference in your decisions going forward.
For example, I had a really strong reputation as a tutor back in Israel before I left, I spent years building that reputation. However, moving to the UK was the right decision for me because I knew I would earn more as an accountant than as a tutor in the long run. Would I have gotten all the time and effort back if I stayed in Israel? no. So I moved in 2015 and am very happy I did.
Are you stuck in a job that you don’t enjoy and underpays you? start looking elsewhere. It doesn’t matter how long you’ve been with your company, you will not get that time back.
The year of less
In her book, “The year of less” (which I reviewed here last week), Cait Flanders says she looked at all the “stuff” she had in her home. She knew she no longer needed all that stuff that she (once) spent so much money on. If she kept everything, would she have gotten her money back? no. If decluttering her home will make her life better (and it did), should she keep everything just because she paid for it? of course not. She actually got rid of around 70% of her belongings and was much happier.
Don’t get me wrong, if you can sell or give it to someone, that’s much better than throwing it away. Cait didn’t just throw her stuff into the bin either.
What I’m really trying to say is that the money’s gone and you can’t change the past so let’s move on. It will make our lives much better.
Using sunk cost to your advantage
I explained how our emotions influence us to make irrational decisions. However, sometimes, we can “give in” to these emotions and actually use that to our benefit.
A bit of background
In October 2020, we went to Israel. During quarantine, I barely moved. I lost some weight (probably muscle mainly) and it was not good for my health. I made a decision that I will walk at least 10,000 steps a day, this will ensure I don’t have weak days, where I do nothing (physically) all day.
The past 8 months
16/10/2020 was the last day in which I walked less than 10,000 steps, I haven’t missed a day since. There were days where I walked 8,000-9,000 and realised that in the evening, that’s when I started walking from the kitchen to the living room and back until I got to 10,000. That wasn’t too bad.
On days that I naturally walked more than 10,000 steps, there was no action for me to take, perfect.
However, what about the time I was tired, about to go to bed and saw I only did 4,500 steps? I actually felt so bad about breaking the “streak” that I walked (indoors) for over an hour before hitting the 10,000 and going to bed.
Was it the ideal decision at the time? I don’t know, I’m not sure.
On one hand, I was tired and probably needed sleep.
On the other hand, it kept the streak going (and lowered the chances of me breaking it even further). It also prevented me from having a weak day.
Would any of the decisions (to walk or to go to bed) be able to change the past? nope. In a perfectly rational world, I would have probably ignored the past, valued my sleep more than my steps and gone to bed. However, I used the sunk costs concept to further reinforce (what I see as) a good habit.
In the exact same way that I reinforced my good (in my opinion) habit, you can start a new habit that will help you to reach FI.
You can use the knowledge about sunk costs in 2 ways:
- Realise you can’t get your time back, so no point in keeping bad habits (ignore sunk costs), embrace change.
- Consider all the time spent (although you can’t get it back) in your favour and reinforce good habits.
Anyway, I’m on 6,600 so time for me to walk around our home before England vs Scotland, have a great weekend!