Sunk Costs Are Confusing

Accountants sometimes have trouble explaining the idea of “sunk cost” to business people.  They would have even more trouble explaining the idea to the rest of us.  Most of us do not want to dispose of something older if it still seems to have some life in it.  The gist of the idea is difficult to see from the human view point.

So we shall enlist the services of the man from Mars.

His unique characteristic is that he knows nothing about how our value system works and he knows nothing about how conditions came to be the way they are now.  The past has no hold on him.  He is completely objective and all decisions are made on present and future utility.

Every decision we make should optimize the present and the future.

If I buy a clothes dryer that costs $800, will last 10 years  and costs $300 per year to operate, I have a 10 year future cost of operations of $3,000. The $800 is in the past.   Sunk.   The day after delivery, a new product hits the market.  It will do everything my dryer will do, will last 10 years or more, will cost $900 to buy and will operate for $150 per year.  What should I do?

Most people curse their luck and carry on with the old one.

The important element of all this and the one the man form Mars would fixate on is “You will spend $2,400 over the next 10 years by buying the new one, or you can spend $3,000 over the same time by keeping the old one.  Why are you thinking about it?”

The $800 purchase is irrelevant to the decision because it does not affect the meaning of the future. It is sunk.  Already in.

Failure to understand the idea of sunk cost is why people keep securities they would never buy under present conditions.  What has happened before today has no rational effect on the decision, yet people confuse themselves with history.

With securities, the rule is that a decision to keep is analytically identical to a decision to buy.  After I make the choice I will have either money equal to its present price of the security or the security itself.  How I came to the present does not matter, except maybe for taxes.  If the man from Mars appears tomorrow he will see only that I have cash or I have securities.  He will not be able to tell how I got that way.  Based on future expectations, you should not keep anything you would not buy at the price available.

How you come to a position does not affect future meaning.  

It can affect more than money. Because you trained to be a dentist does not mean you cannot become a concert pianist.  Evaluate all decisions on how they affect your future.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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