Have you ever had to cut your losses in a financial sense? It's the worst.
Here's a list of all the big dollar times that I had to cut my losses:
1. Buying a condo and selling it for $25K less than purchase price 7 years later.
2. Buying a whole life insurance policy and losing approximately $2.5K in one year.
3. Buying a whole new wardrobe post college ($1.2K), and dropping 25 pounds within 4 months of buying it (my weight loss secret is recovering from an injury)
Not to mention the way to many times that I've purchased a bevy of rare ingredients for a recipe that barely worked out, the Groupons that I purchased for restaurants that were a bust, and the time in college where I tried to get into rap music (okay, that one only set me back about $15).
The thing that all of these scenarios have in common is that they are examples of sunk costs. The best choice for me going forward was to recover as much as I could financially and accept the loss. If I would have insisted upon clinging to the "original plan" and holding onto the object, I would have eventually incurred much greater losses than if I just cut and run.
If you don't let sunk costs sink you are setting yourself up for death by a thousand cuts (or equally unpleasantly, bleeding the horse dry).
Can I avoid sunk costs?
Sadly, most of us (who are still engaged in the financial system) will continue to face sunk cost scenarios for the rest of our lives. That said, there is hope for those who hope to avoid throwing money down a money pit. You can conduct a prospective cost analysis to determine whether or not the risk associated with taking on "sunk costs" will be worth it.
If you want to understand how I conduct prospective cost analysis, keep on reading.
Step One: Determine your potential downside
This is actually not too hard to do. Your downside is however much money you are responsible for paying* less your "salvage value". Salvage value is not always clear but it's typically a number just north of zero.
For example, if you a buy an investment, and it turns out that the investment was actually a Ponzi Scheme, then you'll get about 10% of what you put into the vehicle after some lawsuits make it through court etc.
Sometimes your salvage value is actually negative. Like if you have to take a broken fridge to the dump. If your salvage value is negative, you're going to have to bring money to the table to get rid of the sunk cost. That's a pretty sucky situation to be in, which is why we're doing this analysis!
*One thing to remember is that debt is a way to incur a cost without fully bearing the weight of the cost immediately, however, you are still responsible for the full amount of the debt.
If you find yourself in a sunk cost scenario in which debt is a factor, it's still best to step away from the scenario, but you will either have to continue paying the debt (likely through debt restructuring), bring money to the table, or declare some sort of bankruptcy (short sale, foreclosure, Chapter 7, Chapter 11, etc.). When these factors come to bear, the effect is an immediate loss in financial and life agility which is why my husband and I avoid debt. However, a lot of really smart people don't care about that, so you could listen to them to.
Step Two: Determine the associated ongoing costs
Sunk costs wouldn't really be a problem except that they have associated ongoing costs as well. These costs can be both fixed costs and variable costs, but they aren't normally too tough to figure out. For example, if you buy a house, you have to pay insurance and taxes (fixed), and utilities and maintenance (variable).
If your house is suddenly worth nothing (for example if its located in Detroit), then the ongoing costs that you paid into the house are sunk costs too.
Understanding these costs will help you understand just how much money you might pour into something if it doesn't work out and you call it quits after 3-4 years.
Step Three: Determine your ability to bear the ongoing costs independent of a return
It's time for some real talk. This where most people generally, and entrepreneurs specifically go wrong. Most people are a bit too optimistic about their timeline for a return. As such, they pour a bunch of money into their business, their rental properties, their investment, their whatever, and suddenly find themselves in a pinch because they aren't generating the cash flow that they expected.
If you can't bear the ongoing costs of the investment, independent from cash flow on the investment, you might give up on your investment too soon. That's what happened to my husband and I with the condo. If our renters would have failed to pay rent for one month, we could have been okay, two months would have been tight, and three months without rent would have put a crimp on our finances because we would have started to dwindle our savings without any ability to build them back up unless the rent started flowing.
The inventor of FamZoo.com, stated in his So Money interview, stated that he had enough money to continue FamZoo (his company) independent of revenue, indefinitely. I have a good feeling that the sunk costs in his business will ultimately have a great ROI.
Your ability to bear the ongoing costs ultimately determines your requirement of walking away from an investment. The longer your time horizon, the more likely you will be able to walk away with an ROI. Now, I should be clear, even if you can bear the costs, it doesn't mean you should- that's what evaluating sunk costs (or prospective costs in this case) is all about.
Step Four: Establish Realistic ROI timelines and amounts
After the time that you spend all your money, how long will it be until you expect to see returns? How big will your return be?
If you are purchasing a property to flip, then you can expect an ROI until you sell the place, and your Return on investment will be the difference between the purchase price (estimated through market research)- cost of purchase- cost to rehab. What's that amount? Is it 5%, 10%, 300%?
Small businesses and "investing in yourself" are a little fuzzier when it comes to ROI. The best advice I've ever heard about this type of investing is that if you think you'll have trouble attracting venture capital to take on the risk, you'll probably perform a little below average. Average restaurants fail within 3 years, meaning the average restauranteur walks away with a negative ROI. If people are asking for your services already, if experienced people are already wanting to go into business with you, then you can use average to slightly above average to establish your timelines and your return on investment.
If you are purchasing a money saving device, how long will it be before you start saving money? (The answer to this question should be immediately, if its not, you probably shouldn't buy that thing). How long will it be until you recoup your costs? This point explains why my husband and I didn't buy cloth diapers- It takes practically an entire childhood to recoup the costs.
Step Five: Investigate alternatives (and I don't mean debt)
Sometimes, going all in with your finances is just too much risk to take. Are there different ways to spend that will mitigate your risk? For example, could you sign a short term lease at a higher cost rather than signing a long term lease? Could you pay for 18 months of web hosting services instead of 3 years? Can you substantially lower your phone bill without switching phones?
If you listen to enough late-night real estate guys, you might think that debt is a way to mitigate your risk. The only way that works is if you are a scum bag who is intending to default on debts unless everything works out perfectly.
Sometimes you won't have other options, and sometimes you will. It's important to be open to less risky options even if you ultimately decide against them.
Step Six: Decision Time
From this analysis, you will only occasionally find clear answers. For example, if you have determined that you can pay for your ongoing costs for two years, but you shouldn't expect an ROI for four years, then you can say that this idea is a bad one for you. Or maybe you've determined that there is no ROI. That's okay- you can throw money down a money pit if you want to, but it will be a sunk cost. Like most spending.
Even if the answer is not clear, you will still have a robust decision making framework, so you don't get trapped in something that you should have forseen but didn't.
Maybe you'll stick to your original plan, and everything will go well for you. Maybe you'll choose to stick the original plan, but you'll eventually have to realize that those were sunk costs. Maybe you'll choose a less costly option that leads to a lower ROI, but you'll be happy because it worked out.
When do I do this?
I do this anytime that I am tempted to call something a tool or an investment and it costs more than $100. Luxuries are obviously sunk costs, so I don't worry about that- I just worry about enjoying them. Anytime my husband or I purchase cell phones, cars, computers, houses, investments, shoes, bikes, classes, books (when purchased in bulk), subscriptions, power tools, materials for our house etc, we apply this extensive rigor because we really don't prefer to lie to ourselves about how risky or not risky a certain decision is.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.