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How Thinking
Affects Investing


Sunk-cost Effect

When you spend money that cannot be recovered, economists refer to it as a SUNK COST. For example, let's say a company budgets $100,000 to develop new software for internal use. After three months, they have spent $25,000. The $25,000 is a sunk cost, because it can never be recovered.

As a general rule, it is best to ignore sunk costs when you make investment decisions. What's done is done: changing the future can't change the past. Nevertheless, it is common for investors to be influenced by sunk costs, a cognitive bias referred to as the SUNK-COST EFFECT.

Being aware of the sunk-cost effect can save you a lot of money. In the example above, let's say that, after three months, the managers of the company developing the software realize that it will never actually do what they need. However, they choose to maintain the project because they have already "invested" $25,000. This is the sunk-cost effect. (A sadder example would be an engaged couple with serious misgivings, who agree to go through with their marriage because they have already spent a lot of non-refundable money on the wedding.)

As an investor, sunk costs should never influence your decisions. When you see a loss, do your best to re-focus on your goal and make the best decision you can, assessing the situation as rationally as possible on its own merits.

Example: You have spent $10,000 on Stock A, which then drops in price to $7,000. However, you believe that you can make more money by selling Stock A and buying Stock B. Since your goal as an investor is to make as much money as possible, the best decision is to make the change, even though it means acknowledging a sunk cost of $3,000.

Harley's Rule of Investing #6

Once money is gone, you can't get it back — so don't try.

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