Sunk-Cost Effect

Traditional economics predicts that people will consider the present and future costs and benefits when determining a course of action. Past costs should not be a factor. Contrary to these predictions,people routinely consider historic, nonrecoverable costs when mak­ing decisions about the future. This behavior is called the sunk-cost effect. The sunk-cost effect is an escalation of commitment and has been defined as the "greater tendency to continue an endeavor once an investment in money, time or effect has been made."

Sunk costs have two important dimensions—size and timing. Consider the following two scenarios:

A family has tickets to a basketball game and has been antici­pating the game for some time. The tickets are worth $40. On the day of the game there is a big snowstorm. Although they can still go to the game, the snowstorm will cause a hassle that reduces the pleasure of watching the game. Is the family more likely to go to the game if they purchased the tickets for $40 or if the tickets were given to them for free?

Most people think the family is more likely to go to the game if they purchased the tickets. You see, the $40 cost of the tickets does not factor into the hassle of the snowstorm or the pleasure derived from the game. Yet people consider the sunk cost in the decision as to whether to go or not. A family that pays for the tickets opens a men­tal account. If they do not attend the game, they are forced to close the mental account without the benefit of enjoying the game, resulting in a perceived loss. The family wishes to avoid the emo­tional pain of the loss and, therefore, is more likely to go to the game. If the tickets are free, the account can be closed without a benefit or a cost.

This example illustrates that the size of the sunk cost is an important factor in decision making. In either scenario the family had tickets; however, it was the cost of the tickets ($40 versus $0) that mattered. The next example illustrates that the timing of the sunk cost is also an important component.

A family has long anticipated going to next week's basketball game. On the day of the game, there is a snowstorm. Is the family more likely to go to the game if they purchased the $40 tickets one year ago or yesterday?

In both cases, the $40 purchase price is a sunk cost. However, does the timing of the sunk cost matter? Yes; the family is more likely to go to the game if they purchased the tickets yesterday than if they purchased the tickets last year. The pain of closing a mental account without a benefit decreases over time. In other words, the negative impact of a sunk cost declines over time.

ECONOMIC IMPACT

The previous examples demonstrate that people are willing to incur monetary costs to facilitate their mental budgeting process. Remember that people tend to prepay for some purchases but that they prefer to get paid after doing work. By accelerating payments and delaying income, they are not taking advantage of the time value of money principles. Traditional economics would predict that peo­ple would prefer the opposite—delaying payment and accelerating income to maximize the present value of their wealth.

Mental accounting causes people to want to match their emo­tional cost with the benefits of a purchase. Their determination fre­quently leads to costly decisions. Consider the following example:7

Fifty-six MBA students were asked to select a loan to finance the $7,000 cost of a home-remodeling project. The project involved redecorating (new carpet, wallpaper, paint, etc.) and would last four years, when they would have to redecorate again. They had two loans to choose from: a 3-year loan with 12% interest and a 15-year loan with 11% interest. Both loans could be prepaid without penalty.

Note that the long-term loan has a lower interest rate. Additionally, you could convert the 15-year loan into a 3-year loan (that has a lower interest rate!) by merely accelerating the payments. That is, you could calculate the monthly payment needed to pay off the 15-year loan in only 3 years. Because the interest rate on the 15-year loan is lower than on the 3-year loan, the monthly payments would be lower. When asked, 74% of the MBA students preferred the 3-year loan. These students indicated a willingness to incur monetary costs (in the form of a higher interest rate) to make it easier to integrate related costs and benefits. It seems that the students were willing to pay a higher interest rate in order to guarantee that the loan will be paid in only 3 years.

MENTAL ACCOUNTING AND INVESTING

Decision makers tend to place each investment into a This mental process separate mental account Each investment is treated can adversely affect separately and interactions are overlooked your wealth in several ways. First, men­tal accounting exacerbates the disposition effect covered in Chapter 5. Remember, you avoid selling stocks with losses because you do not want to experience the emotional pain of regret. Selling the losing stock closes the mental account, triggering regret.

Consider a wealth-maximizing strategy of conducting a tax swap. When you make a tax swap, you sell a stock with losses and purchase a very similar stock. For example, say you own Northwest Airlines, which has experienced a price decline along with the entire airline industry. You could sell the Northwest stock and purchase United Airlines (UAL). This tax swap allows you to capture the capi­tal loss of Northwest stock to reduce your taxes while staying invested, waiting for the airline industry rebound.

Why isn't the tax swap strategy common? You tend to consider the selling of the loser stock as a closing of that mental account and the buying of the similar stock as an opening of a new mental account. This causes two outcomes that affect you. First, the interac­tion between these two accounts increases your wealth. Second, the closing of the loser account causes regret. You tend to ignore the interaction between accounts. Therefore, you act to avoid regret instead of to maximize wealth.

Mental budgeting compounds the aversion to selling losers. Consider how you value the timing of payments and benefits. As time passes, the purchase of the stock becomes a sunk cost. The emotional pain of wasting some of the sunk cost on a loser dimin­ishes over time.9 It may be less emotionally distressing for you to sell the losing stock later as opposed to earlier.

Finally, mental account Tne tendency to overlook the interacdon ing affects your perception of between investments causes vou to misper-portfoiio  risks The next Gejve the risk of addng a securitv to an exist-chapter describes how mental jm portfolio.

accounting leads to the build­ing of portfolios layer by layer. Each layer represents the investment choices to satisfy mental accounts. This process allows investors to meet the goals of each mental account separately.

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