Imagine you want to take your family on vacation to Yellowstone on your way to a reunion. You plan to stay at a hotel near the park, wake up, and drive through the whole park on your way to the party.
You reserve your room outside the nearest entrance to the park, but before your trip begins that entrance is closed for construction.
You can reserve a room outside another entrance and still achieve your plan, but your first hotel is non refundable. You’d pay more for the same experience.
You choose instead to keep your original hotel only because you’ve already spent the money. You’ll drive to an open entrance the next day and just see half the park.
This is an example of the Sunk Cost Fallacy. You were more focused on money already spent and lost than achieving your ultimate goal.
It’s called a “fallacy” because the money you’ve already spent is irrelevant if it didn’t get you closer to your goals. All that matters is what you do next.
You Can Avoid This Problem In Financial Planning by Focusing On Your Future
Looking backward at losses can prevent you from reaching your goals. Maybe you’ll decide that investing in crypto currency is the best plan and choose Bitcoin. Soon after, while the entire crypto market is up, your Bitcoin investment happens to be down. You may feel you should hold on to your original purchase because you’re afraid of the losses, but you could lose more in the long run if you don’t sell, free up funds and have a fresh chance to choose another currency and achieve your original goal.
A Plan Helps you Guide Decisions by More Than Emotions
It’s important to be able to measure your investment performance against a solid plan. That means you have to create one. Whether you do it yourself, or work with a professional, it’s better to base your plan on tangible goals such as retirement, college costs, or home purchase, rather than an arbitrary rate of return. Working toward a specific goal will help keep your eyes in front of you while focusing only on returns will have you looking at past gains and losses.
Sometimes Sunk Costs Have Hidden Value
It’s not only important to prevent losses from overly determining your future investments, you can also leverage them to achieve your income goals with fewer taxes. Using a strategy called “Tax Harvesting,” if you experience a loss on a taxable account, instead of investing more and continuing to hope for a gain, you can sell it and guarantee a way to offset taxes on other gains you’ve achieved and use the sale proceeds to invest in different but related securities.
Even if you don’t have a realized gain to offset, you may be able to use up to $3,000 a year to offset your earned income for your federal taxes. If your loss is larger than $3,000 then you can carry that loss forward indefinitely and apply it to future gains. You can learn more about Tax Harvesting, including how and when to use it, in this article from Iryss.
Take Control of Your Financial Future
Understanding the Sunk Cost Fallacy is an important step toward financial literacy. You can learn even more using the tools inside Iryss’ personal finance platform. They were all designed to help you improve your financial health and take control of your financial future. Sign up for early-access and benefit from exclusive discounts and benefits.