Behavioural Finance: Works sometimes!

One very important fallacy is called the ‘Sunk cost fallacy’ – which makes us throw more good money after money already gone bad. Typically a lender keeps lending money to one customer hoping that this will enable the borrower to do well and repay ALL the money. Another manifestation of this is called ‘Averaging’ – if I thought Deccan Gold was a good buy at 83…it has to be a GREAT buy at 23. This is the logic. Not true. The worry is – sometimes it is true. So chasing the rainbow can be quite a battle.

Suppose I have promised my Mother and Daughter to take them to a play. Both of them were very enthusiastic a week before the play. However on the day of the play (it is at 6 pm, and it is a 24 km drive) at about 3 pm, my mother is feverish. My daughter is almost indifferent because suddenly she has got a birthday invitation for 7pm. I am myself not too keen to drive in Mumbai’s blinding rain. Frankly not sure whether the play can take place – the rains may not allow enough people to reach.

How do I react to this situation:

Consider 3 scenarios:

a. Some Investment company has given me 3 free passes

b. I paid Rs. 3000 for this play

c. I have to go there and buy the tickets

In case of (c) it is easy to drop the plan. In case of situation (a) it might cause some embarrassment to explain why I could not make it.

However in case of (b) – my Mom knowing I have paid 3k may hide her fever (why lose 3k), I may risk skidding on the road, my daughter may not go for the birthday party. We might go to the play – which may not happen, my car could skid, my mom could develop high fever…all this for 3k which was SUNK already!

Thus the most sensible solution (tear the tickets dammit!!) is not so easily visible. That is sunk cost fallacy.

However if you have joined a swimming pool and paid Rs. 12k for the year – you are likely to pull yourself on a cloudy day, rainy day, lazy day, cold day,….BECAUSE you have paid the money. However if you had to pay Rs. 175 every time you went to the pool, and it involved spending Rs. 40 on auto (or Rs. 25 on your car)….you might have an EXCUSE! So ‘sunk cost’ works here – IT FORCES YOU TO go….!

So understand where you do not want the sunk cost theory to work, and where you want it to work….and then act accordingly!

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3 Responses to “Behavioural Finance: Works sometimes!”

  1. Dr Mohammed Ali Khan on July 27th, 2009 at 10:05 pm

    Ive reading books on behavioral finance and Ive never heard of any body explaining sunk cost fallacy with such lucidity.. Great Mr Subramani

  2. thanks Dr. Khan.

  3. Vanga Rajendra Prasad on June 1st, 2013 at 7:27 am

    once you rightly said ‘charge for advice to charge the listener’. Once he pays for financial advice, sunk cost theory starts working… nice.

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