Throwing good money after bad and how to stop it

Saturday, 23 April 2016 | MYT 9:10 PM

Throwing good money after bad and how to stop it

by mark reijman

A SUNK cost is any cost that has already been made and cannot be recovered. When making a decision, these costs should not be taken into consideration, because regardless of the decision, these costs will not be retrievable. 
Only the costs that can still be avoided – future costs – should be taken into account.

Lost investments

Assume you have invested RM10,000 in a venture and this money is not recoverable, for instance it is spent on IT development. 

This investment has yielded zero revenues. However, if you invest another RM10,000, you will be able to generate revenue of RM12,000. 

Should you do it? Clearly the total cost of RM 20,000 outweighs the revenue of RM12,000. This means that if you had perfect foresight before investing any money, you should not have invested at all.

But we rarely - if ever – have perfect foresight. The fact is that the first RM 10,000 has already sunk and you can do nothing about it. 

The relevant question now is whether you should invest RM10,000 to generate RM12,000. The answer to that is yes, because your total loss will be reduced from RM10,000 to RM 8,000.

The sunk cost fallacy plays a role whenever someone utters the phrase “we shouldn’t throw good money after bad”. 

It means we shouldn’t spend money which we can recover, just because we spend money in the past which we can no longer recover.

Concert

Let’s say you buy a ticket to a good concert for RM400 and later you also buy a ticket for a great concert for RM 100. 

Both concerts are on the same day and you have no way of reselling the ticket. What would you do? Go to the great show and waste the RM400 ticket of the good concert, or the other way around? 

Although a great concert definitely sounds better than a good concert, the idea of wasting RM400, rather than RM100 makes many people decide to go to the good concert and only waste RM100. In reality, you will have spent RM500, regardless of your choices. Hence, it makes sense to use the cheaper ticket and go to the great concert.

However, in real life, people act less rational, and despite the irrelevance of sunk costs, they still influence many decisions. In fact, they are all around you. 

For example when you:
* Continue to watch “Batman v. Superman: Dawn of Justice”, long after you realised it is not your cup of tea, because you already paid for the tickets.
* Continue to read a book which started to bore or irritate you after the first two chapters, because you feel you wasted your time otherwise reading the first two chapters.
* Continue a relationship that you know is unhealthy and has no long term potential, because you have been together already for so long.
* Continue a war with many casualties, because otherwise all the previous soldiers will have died in vain.
* Continue to believe in something - even if it is demonstrably false - because you have believed it for so long that it has become part of your identity and is too hard to give up.
* Continue with an investment even though you know the economics will never work, because you have already invested so much into it (as the British and French government did with the development of the supersonic Concorde passenger plane).
* Continue to eat, even after you are no longer hungry or enjoying your food, because you already paid for it.
* Continue to play FarmVille, Angry Birds or CandyCrush because you already bought so many power-ups and spend so much time reaching level zillion.
* Continue sending small (but increasingly larger) payments, to cover the legal and customs expenses of your Nigerian prince, before he can send you his fortune.
* Continue to wear that suit or dress that you loved in the store, but hated when you put it on at home, because you have paid good money for it and it would be a waste not to wear it.

Why do we do these things?

For one, we have an aversion to loss, even admitting to it is hard. 
Second, we don’t like to give up, even if the cause is not ideal. 
Third, we don’t like waste, it feels sinful. 
Fourth, we want to prove to ourselves that we were right all along (even if we really aren’t).
Fifth, we don’t want to change our minds under the watchful eyes of friends.
Sixth, we may underestimate the positive things that come from actually giving up a doomed project (more time and resources for better ideas).

How can you improve your decision making?

Let bygones be bygones.

Realise that whatever course of action you take, you will not get back the time or money you have already invested in it. It’s lost, get over it.

Reflect whether finishing that book, meal or movie really makes you happier, or if there is any other course of action that would actually make you happier?

Mark Reijman is co-founder and managing director of [You must be registered and logged in to see this link.] to increasing financial literacy and to help you save time and money by comparing all credit cards, loans and broadband plans in Malaysia.