With apologies to readers currently living in lockdown, here is a question for you: you and someone else have paid $100 for two ‘gold class’ tickets to see a movie at the cinema. About a third of the way through watching the movie, you realise that this is possibly the worst film you have ever seen. Do you leave immediately and go to do something else, or do you stay and watch the end of the film?
Different people answer this question in different ways, but there are generally only two alternatives. One is to leave as soon as you realise you are not enjoying the movie. The other is to stay to the end.
Many people who choose to stay to the end will do so because, in their mind, they are deciding that they do not want to ‘waste their money’ by leaving early. This is a common response. But, from a financial point of view, it is also irrational.
Leaving early is not the point at which you waste your money. You actually wasted your money when you purchased the ticket. Unfortunately, for things like movies, we cannot know beforehand whether the movie will be enjoyable. So, there is always a risk that you will buy tickets to a dud movie. Indeed, at least once in your life, you will buy tickets to the worst movie you have ever seen (at least in a cinema). That is how these things work.
Small items like movie tickets are generally nonrefundable. That means that, once you have bought the ticket, the money is completely spent and cannot be retrieved. Economists and financial advisers refer to such spending as a ‘sunk cost.’ It is sunk because you cannot get it back.
In decision making, sunk costs need to be given little weight. That is because they typically do not change depending on the decision you make. When you are sitting in the cinema, wondering whether to leave or stay, you will not get your money back under either alternative. The money is gone. Your decision is no longer about the money. It is about how you want to spend the next hour of your life.
When you frame the decision like this, the rational decision becomes quite obvious: who would choose definite unhappiness (staying in the cinema) over potential happiness (whatever else you might go to do)? The decision to leave is a form of cutting your losses – not adding wasted time to the money you have already wasted. And yet…
Most people would probably stay in the cinema until the bitter end!
For small items like movie tickets, this probably does not matter. But the tendency to give weight to sunk costs can lead us to make bad decisions. A while ago ‘an adviser acquaintance’ of ours had a client come to see them. The client had bought a business that was going badly. He was trying to decide whether to borrow more money to keep the business afloat. Part of his thinking was that he ‘wanted to get his initial money back.’ This is a very tempting line of thought, but you can see how dangerous it is. The new loan needed to be contemplated on its own merits. Nothing could bring back the money already lost. If the new loan did result in a profit, this was due to the new loan, not the old purchase price.
Ignoring sunk costs can be difficult. This is usually because we do not want to accept that we have made a mistake. But if we ignore our mistakes we risk throwing good money after bad. Once again, it pays to be humble: people who are prepared to accept and forget their past mistakes end up making fewer mistakes.