Sunk cost, opportunity cost, and the endowment effect. You may expect these textbook-weight words to show up in the classroom. You may even imagine how understanding these concepts could help better explain corporate, institutional, or public policy matters—or at least your investment portfolio. But it’s harder to imagine utilizing them to make better decisions in everyday life.
Yet that is where activating an understanding of these and other theoretical models can have the biggest impact: in our lives.
I look forward to the third weekend in April every year, when a fantastic music, food, and drink festival is held in Charleston, South Carolina. Two stages with great live music running from lunch until well into the night, the amazing food for which this gem of the lowcountry has become known, served up by a circled fleet of food trucks and several thousand of your closest friends, all positioned at the water’s edge on a point in the Charleston harbor. Priceless, right?
No, the price tag is actually pretty significant, and that’s why we had such a hard time making a tough decision at this most recent festival. But as my friend and CEO often says, “With better data, we can make better decisions.” And indeed, once we had all the data—and applied a couple of principles directly from your college behavioral finance textbook—the decision, while not easy, was simple.
The lineup for both days was great, but we were most looking forward to Sunday’s sets. My wife, son, and I met up with some great friends from out of town. We hugged, ordered food and drink, and posted up to listen to some sure-to-be exceptional tunes.
And then it started to rain. We knew the forecast and expected an afternoon thunderstorm, so we were prepared. We threw on our raincoats, found some cover under the outer edge of a tent filled with a rush of shelter-seeking beer drinkers, and stretched our ears to hear as much music as possible from a slight distance.
Our musically inclined son—attending his first-ever music festival—eschewed the notion of comfort and posted up in a sopping mob with the many heartier [read: younger] fans while the music continued unperturbed. He’d check back every few songs to make fun of us and goad me to join him, while I kept smiling and pointing to the radar app on my phone insisting, “It’s about to blow over—I’ll be right there; I promise!” (Sidenote: Two of the most dangerous words in parenting are, “I promise.”)
It didn’t blow over. In fact, in quite an unusual fashion for this coastal city where fast-moving storms often breeze through and leave a beautiful day in their wake, this one just sat on top of the festival—seemingly content to stick around just as all the offshore boaters it scared off left to find a dry port. As the rain intensified, the temperature dropped, and the sideways wind rendered our once-coveted parcel under the tent shelter-less.
The radar also started to tell a different story, suggesting there may be no end in sight for at least four hours. We were forced to choose between music and misery. If I were still 18, like my son, I’d like to think I’d have chosen the music—but even he, cold and soaked to the bone, didn’t put up a fight when I suggested, “Let’s chalk this one up to sunk cost and head to the car.”
“Uh, ok, whatever sunk cost is,” he said.
“I’ll tell you in the car.”
“That’s okay.”
And yes, that’s what happens when you’re driving home from a concert with a financial advisor—you discuss behavioral finance. But I couldn’t help myself because the application was just too good.
“The theory of sunk cost,” [audible sigh from the back seat] “suggests that regardless of what has already been invested in any endeavor, your next decision should be the best decision regardless of the investment made.”
I implored that this was exactly what happened to us. The ticket price, the drive, the parking, the walking, the waiting in line—that’s all in the past. If a change of course in the present should lead to a better future, that’s our choice to make. “Would you rather spend the next four hours straining to hear the music through the rain that is making us miserable—or get a warm shower and make it a movie night in the comfy confines of our couch?” I asked.
“Well, I happen to be partial to opportunity cost,” my son spoke up, with a chuckle surely suggesting he was more intent on mocking his father’s nerdy choice of conversation than debating economics. Indeed, an understanding and appreciation of opportunity cost can also improve our decision making. Whereas we tend only to weigh the actual cost of a single decision, opportunity cost also weighs the loss of the road not chosen.
For example, in the choice of where to attend college – the biggest life decision most young people make up to that point—virtually every aspiring academic will weigh the actual cost of each college. The wise will also further examine whatever data the colleges can offer to determine the probability that they’ll land a job after getting their diploma, and the wiser still will research what the average graduate from that university is making in their chosen field post-graduation.
The wisest will also consider the opportunity cost—the opportunities missed in that four-year college experience that costs, on average, about $41,000 per year in the U.S. (according to the National Center for Education Statistics). But that cost is compounded by the income the prospective student could’ve been earning instead of studying—the opportunity cost.
At my son’s high school, for example, students could take courses that prepare them to take the ASE auto mechanic certification as a high school senior. An entry-level ASE-certified mechanic makes around $40,000, on average, bringing the total financial cost of a four-year degree to at least $324,000—without inflation (hah!). The even fuller opportunity cost analysis of this (and any) decision would also weigh the non-numerical factors—like the life experiences missed while you were tethered to campus.
No, I’m not suggesting that the opportunity cost tips the scales in this particular example; indeed, I believe that *for many, if not most, 18 to 22-year-olds,* the long-term personal and financial benefits of a college education still win out, if only financially. Yet I wonder if the many young people who don’t feel like checking the college box could make a better case to their insistent parents using an argument for opportunity cost.
The point is that we can feel even better about that—or any—decision when we’ve also considered the impact of opportunity cost.
“A-hah—that’s a very good point,” I acknowledged, “but even though our choice to leave absolutely did mean that we were missing out on some very good live music, we considered that—and still thought we’d prefer to be dry and warm.”
“Well, I didn’t hate leaving under the circumstances,” my son clarified, “but I think if I paid for my ticket, I probably would’ve wanted to stay more.”
I could barely withhold my glee over his unintentional discovery of the endowment effect—and I didn’t include the phrase “endowment effect” in my response, I promise 😊. His observation, however, was verging on a textbook definition. We value that which we own or possess more than that which we don’t. That’s why owners typically handle things differently than renters, borrowers, or those who receive a bequest.
So, what of it? Is sunk cost just an excuse to waste money?
By the life decisions he made, you’d think my father would surely believe it is just an excuse to waste money. He’s a retired electrical engineer of German descent, hailing from a long line of Central Pennsylvania Baptists. Frugality and the Protestant work ethic are coursing through his veins. We’d spend half of a Saturday going to Western Auto and putting our modest vehicles (prized only by those for whom maximum fuel efficiency was considered a feature long before it was hip) up on blocks to change the oil or rotate the brakes.
You couldn’t even buy a fancy coffee with the money he saved, all while expending 8-to-10 person hours on a weekend, no less. From an opportunity cost perspective, I didn’t want to learn how to change oil—I wanted to hang out with my friends. So, when I first learned of these concepts years later, I literally told my dad how wrong he was and explained it in cold, distant, academic terms—you know, like the thing you just learned but don’t really understand yet. He just laughed it off with the wisdom of years, allowing me to enjoy my fleeting moment of perceived condescension.
Then, when I became a dad, I realized that my dad may have cared a lot less about the money he saved changing the oil than the time he gained with his son. That brought him more utility—more joy—than whatever else he could’ve done that Saturday. Hmm. Maybe he understood behavioral economics after all.
And so did my son, by the way. He came home, dried out, waited for the rain to subside, and then went back to the festival to see the night’s headliner—while my wife and I slept soundly.