Sunk costs and mental accounting can be hazardous to your wealth.
Imagine you just arrived at a theater and as you reach into your pocket to pull out the $10 ticket you purchased in advance, you discover that it’s missing. Would you fork over another $10 to see the movie?
Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the theater, you discover you lost a $10 bill. Would you still buy a movie ticket?
In these two scenarios, you effectively lost $10, but here’s where it gets interesting. Psychologists Amos Tversky and Daniel Kahneman of Princeton University conducted the above study in 1984.
They discovered that only 46% of the study participants in scenario one said they would spend another $10 to buy another movie ticket. However, a whopping 88% of the subjects in scenario two said they would still spend $10 to buy a theater ticket.
Here’s what happened.
More than half of the subjects in scenario one created a “mental account” for the theater ticket. They equated the $10 they spent on buying the ticket in advance with the additional $10 they would have to spend to replace that ticket and concluded that the theater ticket actually would cost them $20. Paying $20 for a $10 ticket was a non-starter for 54% of the study participants.
Conversely, in scenario two, 88% of the study participants did not create a “mental account” that equated the $10 theater ticket with the $10 bill they lost on the way to the theater.
But, as you can see, in both scenarios, the study participants still lost $10.
So, are humans completely irrational?
Sort of. The participants who lost the theater ticket succumbed to the “sunk cost” trap. They let the price they paid for the lost ticket affect their decision to buy a new ticket even though the two are technically unrelated.
Investors frequently do the same thing.
They buy a security, watch it go down, and then tell themselves, “as soon as it gets back to breakeven, I’ll sell it.”
But, the fact is, a losing security is a sunk cost and there should be no commingled “mental accounting.” Instead, each investment decision should stand on its own and be made based on the most current information.
Remember, you don’t have to recoup a loss in the same way that you generated it. Sometimes it’s best to take a loss and move on to a more promising investment.
If you enjoyed this post, please consider leaving a comment or subscribing to the feed to have future articles delivered to your feed reader.
Related posts:
- The Resilient Investor: Are Women Better Investors Than Men? In a battle of the sexes, finance professors Brad...
sign up for our 
subscribe to the