Finance Analogies: Disregard Sunk Costs When Investing

A finance analogy explaining why we should disregard time and effort invested in the past when deciding what to do in the future: 500 words.

My first career was in accounting and finance. You’d think that there wasn’t much overlap between finance and psychology, and you’d be right, however I have occasionally come across principles of good financial management that I like to relate to clients. Here’s the first…

Disregard Sunk Costs

When determining whether to commence a project we must assess whether the project benefits will likely exceed the costs. This is not an exact science, but the idea is straightforward – we need to decide whether this is a good investment.

However, project managers sometimes find themselves part-way through a project when the viability of the endeavour is called into question. At this point decision makers may get distracted by what are called sunk costs, which are the costs already incurred on the project.

When deciding whether to continue with this project we should disregard the sunk costs. This is because the sunk costs cannot be recovered; that money has already been spent, so no matter what happens next we are not getting it back. If the stakes are high then accepting this reality may entail facing some complex negative emotions, so we’ll have to let these wash over us if we are to make the right decision.

But we do want to prevent, as the saying goes, throwing good money after bad. So our analysis is like wiping the slate clean and performing the cost-benefit analysis again, to ensure we get sufficient benefit from any further money that we spend.

In a similar way, you may find yourself part-way through a life project, such as a marriage, when it begins to experience problems. Should you continue with this marriage? What if you have been with the person for 25 years? A 25-year investment in a marriage – surely it would be a waste to throw that all away? But these years are sunk costs. You can never get that time back, but you can ensure that the next 25 years are well spent. And it may well be that investing more years in the same marriage would be worthwhile, but it may also be that spending those years by yourself, or with another person, would provide a better return on your investment. Your task is to decide what is best for the future, not justify decisions made in the past.

I have learnt this lesson the hard way by persisting with life projects of my own well past the point at which I should have quit. For example, although my business career had its moments, it was never really for me, but I doggedly persisted with this career because I had spent so much time, effort, and money on becoming qualified. (This wasn’t the only reason of course, but it was particularly significant in the years after I completed my qualifications, when my perceptions of waste were strongest.) If I had accepted this reality earlier I could have enjoyed the benefits of my new career for longer. Better late than never though.