Wednesday, January 30, 2013

That Sinking Feeling

It's Superbowl week, so I thought I'd link to an article about football, "That Sunk-Cost Feeling", written by James Surowiecki in The New Yorker magazine.

(Mr. Suroweicki is also the author of a great book, which I highly recommend:  The Wisdom of Crowds: Why the Many Are Smarter than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations.

On its surface, the aforementioned article is about the New York Jets and their under-performing quarterback, Mark Sanchez.  Although this may be interesting to football fans, it's not why I am bringing it to your attention.  What the article is really about, is the concept of sunk-costs, which defines as the following:
Sunk costs are unrecoverable past expenditures. These should not normally be taken into account when determining whether to continue a project or abandon it, because they cannot be recovered either way. It is a common instinct to count them, however.
Unfortunately, sunk costs are also a real problem in financial planning. We often see clients who have made a financial mistake in the past (such as buying an annuity or life insurance product that was inappropriate for them and expensive).  It is often difficult to get people to sell or walk away from something that they have already sunk money into, even though they are "throwing good money after bad".  This is something our rational selves know is illogical, yet our emotional selves get in the way of making good decisions based on current information and keep us continuing to rationalize the mistakes we made in the past.

As for the Jets:
"The Jets have stumbled into a classic economic dilemma, known as the sunk-cost effect. In a purely rational world, Sanchez’s guaranteed salary would be irrelevant to the decision of whether or not to start him (since the Jets have to pay it either way). But in the real world sunk costs are hard to ignore. Hal Arkes, a psychologist at Ohio State University who has spent much of his career studying the subject, explains, “Abandoning a project that you’ve invested a lot in feels like you’ve wasted everything, and waste is something we’re told to avoid.” This means that we often end up sticking with something when we’d be better off cutting our losses—sitting through a bad movie, say, just because we’ve paid for the ticket."
Happy Superbowl everybody, and may the best team win.