I often find myself applying the Principle of Sunk Cost to many financial problems I encounter.
The Principle, sometimes paraphrased as “don’t chase good money after bad”, holds that certain financial costs cannot be recovered once they are incurred and therefore should not affect future actions or decisions.
A common example (Wikipedia
) is that of purchasing a movie ticket and realizing shortly into the movie that it is quite unwatchable. If you think “well I am not going to walk out of the move (without getting a refund anyway) since I’ve spend I don’t want to lose the money I’ve spend” you would be ignoring this principle. The correct decision would be “I’ve purchased a ticket and that cannot be recovered. Would I sit through this movie if it was free”. The answer may still be no, in which case you should walk out. There are certainly many movies on TV that I chose not to watch, that, thought free, I find a waste of my time.
What does this have to do with housing? Everything, at least when it comes to buying or selling real estate. Let’s assume I’ve purchased a house for 500K which I now have listed for sale. The market has dropped by 50% (which coincidentally it just has, at least where I am writing this from) so your house is now worth 250K, and those are the offers you receive. You could say to yourself “I am not selling and taking a loss of 250K (ouch)”. But applying the Principle of Sunk Cost, you would ask yourself “If I didn’t own this house, and had 250K in the bank, would I purchase it for 250K?”. If the answer is yes, don’t sell. But if you would not even buy it at 250K, you should sell since by not selling you have essentially purchased the house for 250K.
Sometimes that analysis gets a bit trickier. Let’s take the stock market. Say I own 50K worth of stock. We can try and apply the principle and ask “If I had 50K in the bank, would I purchase another 50K worth of the same stock I have?”. If I would not purchase the stock with an additional 50K, I should logically sell the entire 50K worth I already have. But this analysis is incorrect.
The actual application of the principal to the above case holds “if I didn’t own any stock, but had 50K in cash, would I buy 50K worth of stock with that money”. If the answer is no, sell the stock. If yes, keep the stock. Perhaps you would buy 25K, in which case you should liquidate 50% of your holdings.
I hope this explains the Principle and you can apply it to your own situation.