Sunk costs, opportunity costs and the endowment effect. You can expect these textbook words to indicate up within the classroom. You may even imagine how understanding these concepts could help higher explain corporate, institutional, or public affairs—or at the least your investment portfolio. But it’s harder to assume using them to make higher decisions in on a regular basis life.
How can understanding this show you how to?
But that is precisely where activating the understanding of those and other theoretical models can have the best impact: in our lives.
Every yr I sit up for the third weekend in April when Charleston, South Carolina hosts a tremendous music, food and drinks festival. Two stages of great live music from lunch until late night, the amazing food this lowland gem is understood for, served by a circling fleet of food trucks and a number of other thousand of your closest friends, all positioned on the water’s edge some extent in Charleston Harbor. Priceless, right?
No, the worth is definitely quite high and that is why we had such a tough time making a troublesome decision at this last festival. But my friend and CEO often says, “With better data, we can make better decisions.” And sure enough, once we had all the info—and applied a number of principles straight out of your college behavioral finance textbook—the choice, while challenging, was easy.
The line-up on each days was great, but we were most looking forward to the sets on Sunday. My wife, son and I met up with some great friends from out of town. We hugged, ordered food and drinks, and sat down together to take heed to what were sure to be some exceptional tunes.
And then it began to rain. We knew the weather forecast and expected a day thunderstorm, so we were prepared. We placed on our raincoats, found some shelter under the skin fringe of a tent crammed with a crowd of beer drinkers in search of shelter, and strained our ears to listen to as much music as we could from a distance.
Our music-loving son, who was visiting a music festival for the primary time, avoided thoughts of consolation and positioned himself in a cheerful crowd amongst the various warm people [read: younger] fans while the music continued undisturbed. He’d stop by every few songs to make fun of us and get me to hitch in, while I kept smiling and pointing on the radar app on my phone and insisting, “It’s almost over – I am.” almost there; I promise!” (Side note: Two of the most dangerous words in parenting are “I promise.”)
It didn’t fly over. In fact, which is sort of unusual for this coastal town where quick storms often pass by and leave behind a gorgeous day, this one just sat on top of the festival and seemed content to be there, similar to all of the offshore boaters were doing set off to search out a dry port. As the rain became heavier, the temperature dropped and the crosswinds left our once coveted plot of land under the tent unprotected.
The radar also began to inform a special story, suggesting there could also be no end in sight for at the least one other 4 hours. We had to make a choice from music and misery. If I were still 18, like my son, I’d have happily chosen music – but even he, cold and soaked to the bone, didn’t object once I suggested: “Let’s tick that one.” one as much as the sunk costs and off to the automobile.”
“Uh, OK, whatever the sunk cost is,” he said.
“I’ll tell you in the car.”
“That’s okay.”
And yes, that is what happens once you drive home from a concert with a financial advisor – they speak about behavioral finance. But I could not help it because the applying was just too good.
“The Sunk Cost Theory” [audible sigh from the back seat] “suggests that no matter what has already been invested in a venture, your next decision should be the best decision, regardless of the investment made.”
I pleaded that this was exactly what happened to us. The ticket price, the ride, the parking, the walking, the waiting in line – it’s all a thing of the past. If a change in fact in the current is to guide to a greater future, that’s our decision. “Would you rather spend the next four hours straining to listen to the music through the rain that’s making us miserable – or take a warm shower and make it a movie night in the cozy confines of our couch?” I asked.
“Well, I happen to have a thing for opportunity costs,” my son said with a giggle that actually suggested he was more serious about poking fun at his father’s nerdy alternative of conversation than debating economic issues. In fact, understanding and assessing opportunity costs may improve our decision making. While we are inclined to weigh only the actual costs of a single decision, opportunity cost also takes into consideration the lack of the trail not chosen.
For example, when deciding where to attend college—the most important life decision most young people have made thus far—virtually every aspiring academic will weigh the actual cost of every college. The smart ones may also further research all the info colleges can offer to find out the likelihood of them getting a job after receiving their diploma, and the smart ones will research again what the typical graduate of that university will do after graduating from earned in his chosen field.
The smartest may also consider the chance cost – the missed opportunities during this four-year college experience, which costs a median of about $41,000 per yr within the United States (in line with National Center for Education Statistics). However, along with these costs, there’s also the income that the potential student could have earned as an alternative of studying – the chance cost.
For example, at my son’s highschool, students might take courses that prepare them for the ASE auto mechanic certification as highschool students. An entry-level ASE-certified mechanic earns on average around $40,000, bringing the full financial cost of a four-year degree to at the least $324,000—not including inflation (hah!). The much more comprehensive opportunity cost evaluation of this (and some other) decision would also weigh the non-numerical aspects — just like the life experiences you missed when you were campus-bound.
No, I’m not suggesting that chance cost is the deciding think about this particular example; In fact, I imagine that *for a lot of, if not most 18-22 yr olds*, the long-term personal and financial advantages of a faculty education still outweigh, if only financially. Still, I ponder if the various young individuals who do not feel like checking the faculty box could make a greater case to their persistent parents using a chance cost argument.
The point is that we will feel much more comfortable about this or some other decision if now we have also considered the impact of opportunity costs.
“A-hah – that’s a very good point,” I admitted, “but even though our decision to go absolutely meant we would miss out on some very good live music, we thought about it – and still thought we would “It’s better to be dry and warm.”
“Well, I didn’t hate leaving under the circumstances,” my son clarified, “but I think if I did paid I probably would have wanted to stay longer for my ticket.”
I could hardly contain my joy at his unintentional discovery of the Endowment Effect – and I didn’t include the phrase “Endowment Effect” in my answer, I promise 😊. However, his commentary bordered on a textbook definition. We value what we own or possess greater than what we don’t own. That’s why owners often proceed in another way than tenants, borrowers or testators.
So what about that? Are sunk costs just an excuse to waste money?
Based on the life selections he’s made, you’d think my dad would definitely imagine that is just an excuse to waste money. He is a retired electrical engineer of German descent and comes from an extended line of Baptists in central Pennsylvania. Thrift and Protestant work ethic flow through his veins. We spent half a Saturday going to Western Auto and taking our humble vehicles (valued only by those for optimum fuel efficiency long before they were fashionable) as a feature to face on blocks to vary the oil or to show the brakes.
The money he saved couldn’t even buy an awesome coffee while putting in 8-10 hours of labor in a weekend, no less. From a chance cost perspective, I didn’t wish to learn the best way to change oil – I wanted to hang around with my friends. So once I first learned about these concepts years later, I literally told my father how improper he was and explained it in cold, distant, academic terms – you recognize, like what you had just learned but not yet really understood. He simply laughed it off with the wisdom of years and allowed me to enjoy my fleeting moment of perceived condescension.
When I became a father, I spotted that my father could have been less concerned with the cash he saved on oil changes than with the time he gained together with his son. This brought him more profit – more joy – than the rest he could have done that Saturday. Hmmm. Maybe he understood behavioral economics in any case.
And my son too, by the best way. He got here home, dried off, waited for the rain to let up, after which went back to the festival to see the evening’s headliner – while my wife and I slept soundly.
