Opinion & Analysis
When we go climbing, we usually take my friend Derek's car - it is old and he is prepared to give it a greater battering on the rough mountain tracks than I would to my slightly less ancient model. This means that we manage to get further than we otherwise could and so we save a good bit of time and fairly boring walking.
OPINION: Derek is quite proud of his car: it has just clicked over 300,000km and, until recently, given little trouble. He thinks it is worth about $1500. However, he has just put a new cam belt in it (cost: $1000) and following this maintenance he says he has to keep it until 350,000km so that he gets value out of the $1000 he has spent.
The car is the subject of a good deal of banter between us: Derek looks at the $1000 he has just spent on the car and is determined to get that money back by doing another 50,000 km. I think that his $1000 cam belt is a sunk cost and the forthcoming 50,000 km of motoring is likely to be expensive. I tell him that he should sell it now to get his $1500 while he can. Nevertheless, Derek's determination has become intense (as it does sometimes on a mountain) and he'll do the extra 50,000kms no matter the cost.
This is just a bit of a game between us (with fairly low stakes) but it does illustrate something which in finance can become costly: many of us have a tendency to become attached to something and quite fixated on a particular number. We will sink our money into something which deep down we know is a dead duck. And then we continue to sink some more.
You see this most often with investment. People buy investments which fall and then they steadfastly refuse to sell until they get their money back. I wish I had a dollar for every time I have heard an investor say: "I will sell this rubbish investment when it gets back to the price that I paid for it."
This is not sensible as the thing that made you the loss is unlikely to make you your money back - the chances are that the investment is a dog and you probably know you were wrong to buy it. Therefore, get what's left of your money out and get it working for you. In the words of Warren Buffett: "You do not have to make it back the same way you lost it."
And yet, that is what most people do. We find it hard to admit that we were wrong and so we chase a loss down as we hope against hope that the investment will turn around. Psychologically humans won't own up to mistakes (it makes us vulnerable to all sorts of criticism) and when we sell, it lays the fault bare for all to see.
Moreover, loss aversion studies show that losses are about twice as powerful as gains - the pleasure of a $100 gain is half the pain of a $100 loss. When we hold on to a poor-performing investment we can tell ourselves that we have not yet made a loss and so we postpone the pain of selling. At some level we know that the investment dog needs to be sold and the loss taken but we hold out regardless - the drive to avoid the loss is just too strong.
Loss aversion is the reason people stay at the casino trying to make good a gambling loss they have suffered. Rationally, they know the odds are stacked in favour of the house and that their gambling loss is sunk but some will play on to the point of bankruptcy trying to win back their money.
A cost that has been paid is sunk - it is in the past and you cannot do anything about it. The important thing is the future and you should ask yourself what are the prospects of the things that you own? Is this investment the best way for you to get your money back? Or should you just let it go and find something better?
PS. I wouldn't buy that particular used car from Derek.
Martin Hawes is an authorised financial adviser. A disclosure statement is available on request and free of charge, or can be found at www.martinhawes.com. This article is of a general nature and is not personalised financial advice.
- Sunday Star Times