Throwing good money after bad?

In this newsletter, we'll talk about Time, Money & the Sunk Cost Fallacy . . .

Aug 30, 2020

Hey fellas, how’re you doing?

Bad day, is it? Nah..

Nothing is permanent in this wicked world, not even our troubles.

- Charlie Chaplin

Imagine.. you have been a virtuous being all these years. Pleased by your service to mankind, the Almighty grants you a wish, $500 billion for this lifetime or 24 extra hours of life on earth? What will you pick? Hmm? Oh heck, what a dilemma! Well, it’s okay, I know there will be mixed opinions. Oh, and some of us might feel these aren’t comparable, simply because time isn’t quantifiable! Or, perhaps this is subjective.. perhaps one who lacks a pittance or a second, understands its true value!

The debate over time and money is too mainstream! Ergo, I am not here to propagate any such philosophy. But as the upcoming articles will address wealth management, it’s good to get our definitions straight. This will also set stage for the later half of this article. Btw, don’t worry, I’ll keep it short ;-)

You can use your time to make money, but you can’t use money to buy more time!

- arguably, this is the universal truth. We, most often, have an erroneous notion about the filthy rich! Think of those with deep pockets (the likes of Jeff Bezos, Bill Gates, etc), and we just (irrationally) envy to acquire those riches! We decipher only the luxuries of life.. the cars, resorts, pubs and the quintessential lavish lifestyle! Without a sense of the hours and hours of sweat that they have put in to earn those billions! Hear from them, and you’ll know.. time and how you utilize it, is your magic sauce! Time is money, and even more than that! A Chinese proverb puts it succinctly - an inch of time is an inch of gold, but you can’t buy that inch of time with an inch of gold!

Time is the great equalizer. Everyone has the same 24 hours.. not a ‘penny’ more, not a ‘penny’ less! Do you know where the problem lies? It’s that we don’t quantify time in the first place. But it’s, in fact, the most valuable currency. Take it this way.. every day, time-wage worth 24 hours is credited to our account. Just the way we do for money, we need to justify the time spent. Decide on how much time to be spent right away, how much to invest in the future, how much time to set aside for uncertainties and so forth. And, the worst choice is letting these hours slip away. No point in regretting later!

Now, let’s talk about the decisions -

Should you spend a week with a client who offers you ₹25000 right away or should you work on a business idea that could generate ₹2.5 Cr. next year? Should you spend ₹500 per week on laundry services to save a couple of hours on washing clothes yourself? We make such choices frequently. Most of the time, it’s based on our gut feeling and we seldom calculate an hourly value! This is why the grey zone of time-value spectrum persists!

To understand the time v/s value dilemma, you need to consider the following:

The amount of time you spend to earn money.
The amount of money you earn to spend time.

Basically, you have to discover a trade-off between time and value. Suppose you earn ₹150 per hour. You provide for all expenditures and your net take-home is ₹100 per hour. You want to buy a book worth ₹500. So, ceteris paribus, it might take you 5 hours of work to get that book. Now, ask yourself the question.. is it worth? Is that book worth 5 hours of your sweat? What’s the opportunity cost of this choice; i.e. can you spend the money or time in something more productive? Can the money and time invested in the book enhance your skills (of course!) and, directly or indirectly, lead to efficiency in time or further sources of income? It might take a while, but eventually, if you incorporate this habit into your daily life, you will have a stronger plinth to support your decisions.

Technically, you should have in mind your point of indifference. For the starters, indifference point is a point at which you are equally likely to chose option 1 as you are to chose option 2; i.e. the utility of either choice is the same. Let me explain it in layman’s terms. Suppose you are indifferent between ₹100 and 1 hour. This is your hourly rate of indifference. It only goes on to say that you can either spend ₹100 to save 1 hour or (vice-versa) utilize 1 hour to save ₹100. Now, suppose it takes you 2 hours to wash your clothes. Also, you have an option to get it done by a dhobi for ₹500. If you noticed, here the money cost per hour is ₹250 (=500/2), which is more than your hourly indifference rate (₹100). Thus, in this instance, spending ₹250 to save an hour is costly. Ceteris paribus, here, ideally, you should chose to self-wash your clothes.

There are numerous decisions in life that can be interpreted as such. Just do the math! Umm.. no-brainer, right? But wait a minute — it isn’t so easy-peasy all the time. Fixing a standard hourly rate is impractical. It has to depend on the emotions or efforts attached to a task! But you know what, a reasonable estimation isn’t impossible. After all, if something makes you more efficient, why not try to at-least make it a part of daily life?

And yes, for the ‘time-poor’ :

Time is a created thing. To say “I don’t have time,” is like saying “I don’t want to.”

- Lao Tzu

So, here we are. Now that we have talked about time and money, it’s time to introduce you to the integral part of today’s discussion. Here we go —

Sunk Cost Fallacy

Do you ever keep yawning in the movie theatre and still reluctant to leave because you had paid for the tickets? Have you ever kept eating that last piece of cutlet, just to justify the price paid for the dish, though your stomach ached-out in abundance? Don’t you keep pushing yourself in a losing game, just because you started it in the first place? Ever stuck in a ‘painful’ job or career just because you invested a great deal of money, time and efforts in it? To the love-birds, ever hanged on to a long hard-hitting relationship just because you initiated it? If you’re a wannabe-Buffet (a stock market guy), don’t you remain invested in a particular stock with very weak fundamentals, just because of your prior intuition? Oh, even our mighty Government is no exception, don’t they stay put in wars just to justify the prior deaths of soldiers, though it costs the country more and more lives?

Welcome my friend, there’s no denying.. we’re all victims of the Sunk Cost Fallacy!

Investopedia defines it as —

Sunk cost trap refers to a tendency for people to irrationally follow through on an activity that is not meeting their expectations. This is because of the time and/or money they have already invested.

Precisely, people phrase it in five words, as goes the title of this article —

Throwing good money after bad!

Well, let’s think for a while… why did we not leave the movie theatre or stopped licking the plate or broke-up or squared-off our investments? Because in that case, our ‘pre-invested’ time & money would be ‘wasted’! So, ultimately, this is the game of waste-reduction mentality; i.e. unwillingness to appear wasteful, isn’t it? But why go for preventing waste-reduction in circumstances where it works literally the opposite? Why waste more resources just because you were wrong in the first place? Why can’t we train ourselves to know where to opt-in and where not?

Kahneman and Tversky developed the Prospect Theory. Their proposal was that our decisions are based upon our tendency to avoid losses or to attract gains. Because loss sucks! And a loss from the past.. oh, that sucks even more! You know, losses seem to be larger in your history than it actually was when you first felt it! Whenever this inclination towards the past becomes a factor in making decisions about your future, you run the risk of being derailed by the sunk cost fallacy!

Then, some people point out that exit implies inconsistency. And that’s why they term this fallacy as irrational! Well, from the basic Mathematics (Conditional Statements), if a leads to b, that does not necessarily mean that b leads to a. Being rational can surely make you consistent, but being consistent doesn’t always imply rationality! Consistency, in no way, promotes sticking to something even if that’s counter-productive! As Emerson puts it - a foolish consistency is the hobgoblin of little minds, which means only a fool would refuse to change the way of looking at things simply because "We have always done it that way." If exiting a nonviable option means inconsistency, it’s better to be so! But that’s our problem. We find it easy to get in something while the exit becomes really difficult. And what could be a better example than the stock market. We term it status quo bias in the markets. Investors tend to retain their investments, in spite of headwinds, just because they don’t want a change, either due to their love for a stock or due to the efforts they have put in to get those shares. But more often than not, it is detrimental to wealth! If you can’t question your intuition, stock market, definitely, isn’t your thing!

The same is valid for our career, guys. I have been through that phase. A year ago, I had an option to quit something I was half-way through. But I didn’t, solely because I had worked really hard to be there! And then, I spent more money and one whole year justifying that decision, with no zeal at all! But finally I decided not to pursue it, not for the time being at least. See, to err is to human. It is quite natural for us to make wrong decisions. But it’s wise to withdraw wherever it is required. You absolutely can’t undo one mistake by committing another!

The sunk cost fallacy has been wonderfully depicted in a study by Arkes and Blumer in 1985 in the paper — The Psychology of Sunk Cost (Organizational Behavior and Human Decision Processes)

Here, I am citing one of their experiments —

Assume that you have spent $100 on a ticket for a weekend ski trip to Michigan. Several weeks later you buy a $50 ticket for a weekend ski trip to Wisconsin. You think you will enjoy the Wisconsin ski trip more than the Michigan ski trip. As you are putting your just-purchased Wisconsin ski trip ticket in your wallet, you notice that the Michigan ski trip and the Wisconsin ski trip are for the same weekend! It’s too late to sell either ticket, and you cannot return either one. You must use one ticket and not the other. Which ski trip will you go on?

Well, tell me honestly, what would you choose? Hmm? A rational being should have gone for the more enjoyable one - the Wisconsin trip. But the survey reported that more people chose the less enjoyable (more expensive) one - the Michigan trip! And obviously, most of us would have opted for this. But why, I mean don’t you want to enjoy more? Of course, we want to. But the magnitude of amount ‘already’ paid influenced this decision, isn’t it? My friend, that’s the sunk cost fallacy at work! But see.. either way, the money is gone, no matter what. You aren’t getting that back. (Simply put, sunk costs are costs that cannot be recovered). Then, why not go for a better experience? We should realise that incremental costs should influence our decisions and not sunk costs!

Most of such decision bias is because we tend to measure all the outcomes in terms of money! Whereas there are definitely more important factors, for instance, emotions and time (we talked about this dilemma in the first part). And what could be a better illustration than relationships! Well, I have been in one, a happy one. Btw how do you measure success (happiness) in a relation? Certainly not in monetary terms, right? You can’t just build a spreadsheet model to factor in your emotions and predict whether it’s going to work out! It just happens and you just know, no magic sauce. The same works for failure (sadness). But the problem is people are so irrationally committed that they over-estimate the short-term pain and under-estimate the permanent one! You can’t just keep suffering all your life just because of a false commitment. Try your best, and if it doesn’t at all work-out, it’s wise to withdraw. Don’t fake it. Because that’s life, we’re supposed to be in flux, as change is the only constant!

And this phenomenon is particularly prevalent in Government endeavors. Call it, pushing the country to borders to justify prior deaths of soldiers, or investing billions of taxpayers’ money in failed ventures to justify previous stance and so on. Take for example, the unpreparedness for demonetization or the negligence for this pandemic, unwillingness of the Government to accept their mistake is very ridiculous! Similar is the case of ad spends or expansion plans by companies. On the flip-side, there are certain brands who make use of the loss-aversion tendency of customers to ensure revisits with policies like ‘pay now, enjoy later’. And a lot many examples will unveil if we look for it.

Okay, okay, enough of illustrations. So far, I guess we are clear that this is indeed an issue to be cautious about. But, then what? How do I not fall prey to this fallacy? How to get over my past? How to know when to exit? Oh my god, a hell lot of questions! Well, I can not guarantee you an ubiquitous solution, but I can surely provide some suggestions —

Let bygones be bygones. Your past has little to do about your future. Ignore conditions that existed in the past but have become redundant now. Give up your hopes for a better yesterday, hustle to create a better tomorrow.
Be proactive. Wait not for a decision to announce its results. Before you opt-in for something, do the math. Look for reviews before you go for a movie, analyse before going long on a particular stock, think properly before choosing a career, evaluate your partner before committing and so forth. Though this may not guarantee that the decision is correct, this certainly gives you something more than your intuition to back your decision.
Value your emotions, your time just as you value money (discussed earlier). If the movie is boring, if the stock is wrongly over-valued, if your career does not appeal you, if your relation does not work out, just do this — EXIT. Exit while the door is opened, don’t wait till a wall replaces it! Better to be adjustable, better to be inconsistent than regretting going forward. And remember, this decision is crucial, make it only when you are, by all means, in your right senses.

So, that’s it. btw let me remind you.. the sole objective of this blog is in line with aforesaid steps; i.e. to help you make informed decisions for a better tomorrow :)

Uff… a long one it was! But I needed the space to pour my heart out. And if you made it till the end, I really appreciate it. You totally made my day. Thank you so much!

Hope you found it insightful! And if it was worth, please tell a few friends.

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