My wife and I rented a movie the other night on Xfinity. The price was $6.99. Once I confirmed the “buy” icon the second time, the money was committed, there is no way to get it back. Fifteen minutes into the movie we realize it’s a real stinker. There was no way we were going to enjoy the movie.
“I’m going up stairs to bed,” Gail submits, choosing to fall asleep to a 1950’s Turner Classic Movie instead of enduring more pain with me and this stinker in the living room.
“Not me, we paid $6.99 for this move, I don’t want to waste it,” exclaims yours truly.
Or how abut this: Ron leaves home to walk to convenience store eight blocks away to pick up some aspirin. Six blocks into the walk his wife calls his cell phone to tell him that she just called the convenience store and it’s closed. Does Ron think, “Well, I invested six blocks in this errand, I might as well continue, I don’t want to waste the six blocks I already invested? Probably not.
These two examples may help us understand the principal of sunk cost. A sunken cost is an investment that is unrecoverable. Sunken costs should not be taken into account in an investment decision, only prospective (future) costs should be weighed.
Traditional economics proposes that decision makers should not let sunken costs influence their decisions. Doing so would not be rationally assessing a decision exclusively on its own merits.
“I’m here watching this movie, is my time better spent reading or watching the movie?” The cost will be an investment of time of the next minutes. Not the $6.99 that is already gone.
Human behavior, however, often takes into account past investment in decisions. Many times I hear, “But I have so much invested in this already!” often disregarding opportunity costs versus the cost of “hanging on”.
Let me use a real estate example. The Lennon’s purchased a home in Cape Coral in 2006 for $320,000. They put up $70,000 cash and the balance on their mortgage is now $230,000. A BPO (Broker Price Opinion) tells them that the market value on their home is $225,000. They can buy a brand new home today, near the school their son goes to, with the fourth bedroom they need, for $225,000. The mortgage rate on their existing home is 7% and they qualify for a 4% mortgage for the new home; but would have to write a check at closing (or short sale their home).
Existing Home purchase Price $320,000
Existing Home Value: $225,000
Current Loan/Mortgage: $230,000 at 7% ($1867/month based on original loan of $250,000)
If they sell their home at market value they will net only $207,000 after selling costs so in theory it will cost them $23,000 to pay off their mortgage:
Current Mortgage: $230,000
Net sales proceeds $207,000
Short fall $ 23,000
Here is a very key point: What they paid for their existing home has absolutely no bearing on its value. A rational decision would be to evaluate the cost of the move based on future costs: the down payment and mortgage to buy the new home plus the cost of the shortage on their existing home; against the gain of a newer bigger home that is where they want it to be. They should not count the $70,000 already sunk, the payments they made the last 7 years, (sunk), but the future cost to them. The future mortgage payments, the lower energy bills, and the lower cost of maintenance are what should be important to the Lennon family, not what they have sunk into their old house.
New, bigger , energy efficient home $225,000
Current loan rate of 4% on 90% loan of $202.500 ($1508/month)
(Taxes, insurance and maintenance savings could be an additional $300/month over the existing home). So the savings on cash outflow may be as much as $8000/ year PLUS they get the home and location they want. The investment for the future is about $45,500 ( pay off old loan and deposit for a new home) and this $45,500 returns $8000 per year or a ROI of about 17%. Pretty good.
Remember, what you pay for an investment has zero influence on what it is worth. If you inherited a building, you would not ask less for it because of your low cost, why would you expect someone to pay more just because you overpaid?
There are two other factors in Sunken Cost that are interesting. The first is called Overly Optimistic Probability Bias. Once a person has invested time or money in something, they may have an unrealistic opinion of its worth or chance for success. Just ask someone that just bought a lottery ticket if they will buy another one, “no thanks” they offer; they have become confident of their own ticket winning.
Top real estate agents see over optimistic probability almost every time we talk to an owner about selling his house for him. This phenomenon is also called The Endowment Effect. The person demands more to give up an object then they would be willing to pay to acquire it. Sound familiar?
The second factor in play in the Sunk Cost theory is the Personal Responsibility Requisite.
I was the one that wanted that movie mentioned above that was a stinker, darn if I was going to give up! In real estate the personal responsibility factor has more facets – like personally guaranteeing on a loan – a promise was made – and ethical and moral and indeed, legal issues, arise.
We see personal responsibility factor in a business a manager that championed a project that now has become a dead end but he is blinded by the personal responsibility requisite. It was his baby, after all, and he winds up fighting for funding that will not come because more rational minds are above him making decisions on future cost/value analysis.
In real estate I have advised looking at alternatives when making a decision, and the purpose of this article is to emphasize that alternatives to holding onto a property should not be influenced by dollars and time already sunk, but only future cost/value issues.
Don’t hold onto property at the cost of moving forward and having more enjoyment of a higher return because of a past investment, emotions, or sheer stubbornness. In many instances a new home or newer building on the fresh start of an appreciation curve will be a wiser decision than sticking with a property because of a sunken investment or a misguided desire to punish yourself for making that investment in the past.