What an All-You-Can-Eat Buffet Can Teach You About Investing

This post exploring the concept of sunk costs was written by Cameron at Schaefer’s Blog. I warn you know, this post will make you hungry!

All of us have been there before, the food circus known as the all-you-can eat buffet. Pushing aside the snotty-nosed kid in order to secure the last scoop of jell-o salad, we pile up our plates like miniature leaning towers of Pisa and stuff ourselves until we’re sick. For what? “To get my money’s worth!” you say. To this I respond, “You are an idiot, kind Sir!” You have just violated the basic economic principle of sunk cost.

Sunk costs are, “costs that have been incurred and which cannot be recovered to any significant degree” (Wikipedia – Sunk Cost). According to economists, the trap people fall into is letting sunk costs play a role in decision making. Using the example above let’s say you pay $8.99 when you walk in the door of the buffet. The $8.99 is now a sunk cost, you will not recover it no matter what you do from that point on. Whether you make yourself miserable by overeating or eat until you’re full, enjoying your meal, the price is the same. So why do so many people insist on eating entirely too much?

A second example. You love playing tennis and want to play this coming Saturday, but the weather forecast is calling for rain. There are indoor courts available, but they have a reservation fee of $15 which must be paid whether you end up using them or not. You prefer to play outdoors when able, but indoor tennis is preferable to no tennis at all, so you pay the $15 to reserve the court. Saturday comes around and its perfectly sunny. You now have a choice, do you play outdoors, giving up the $15? Or, do you ignore the beautiful weather and play indoors since you already paid the money to reserve the court.

Economists argue that a rational actor should understand that the $15 is a sunk cost and should not factor into the decision of whether to play indoors or outdoors. The money has already been spent and cannot be returned regardless of your decision. But, when it comes to money, people are rarely rational. Most would choose to play indoors to “get their money’s worth,” wasting beautiful day outdoors.

How, you ask, does this have anything to do with investing? Ask yourself how many times you’ve stuck with a loser of a stock, passing up other great investments as you wait for it to “come around.” Or maybe you’ve hung on to an under performing mutual fund simply because you paid an upfront sales charge and didn’t want to see it go to waste. We all like to say that we keep emotion out of our investing, but when you spend money and time on anything an emotional tie is almost sure to result. This tie is great fodder for acting irrationally.

“More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason,” says Philip Fisher, author of Common Stocks and Uncommon Profits.

The reality is that the time studying a particular investment, the money spent, the sales charges paid…these are all sunk costs and should not play a role in our decision making. Future gains and losses should guide our thinking rather than past ones. The individual merit of an investment at present must outweigh any sunk cost. How then can an investor fight the tendency to violate this economic principle?

The University of Missouri Office for Financial Success offered these techniques to counter the sunk cost effect in a June 2007 post:

1. Seek opinions from people who were uninvolved in the original choice.

2. Be alert to sunk cost bias in the decisions and recommendations made by others. “We’ve invested so much already” …

3. Don’t be afraid to admit when you are wrong.

4. Sometimes even smart choices (taking into account what was known at the time the decision was made) can have bad outcomes. Cutting your losses doesn’t necessarily mean that you were foolish to make the original choice.

The principle of sunk cost is incredibly simple, but not always easy to follow. The more money, time and energy one invests in something, the greater chance of irrationality. The next time you are tempted to “get your money’s worth,” think of the all-you-can-eat buffet and how bad you feel when you violate the principle of sunk cost. Make your investment decisions looking forward, not backward.

For other investment principles I talk about on my blog, click here, here and here.

(Photo Credit: Sufi Nawaz)