Sunk Costs: Letting go is hard to do!

The Discussion Issue

When making decisions (investment or other), the rational thing to do is to let go of everything that has happened in the past and focus on the future. In investing, this is of course the "sunk cost principle", but it is much easier to do in theory than it is in practice.

Background

Start by reading this piece on the sunk cost fallacy. It is fairly comprehensive and lays out in layman's terms, why sunk costs are so difficult to ignore. Follow up with this blog post I had from a few years ago on the Yankee's A Rod problem and the broader lessons for any organization that has made bad decisions in the past and feels locked in by those decisions. If you feel in the mood for more reading, there is plenty of material online on sunk costs, both in theory papers and in the popular press.

Making it Personal

Let's asssume that when you joined Stern two (or three) years ago, you had a choice of going to a state college, where you would have received a free ride (tuition and housing costs would have been fully covered) but that you chose to come to Stern on the expectation that it would give you access to higher paying jobs in banking and consulting. Assume that the annual cost of going to school at Stern is $75,000/year and that you have already paid the tuition through the end of this semester. Finally, assume that you still have the option of tranferring to finishing your college degree at the state school, at no cost, for the remaining years of your undergraduate degree.

Assume that once you graduate, you have a 40-year working career ahead of you (depressing, right?) and that the salary increment that you get from a Stern degree is a constant (i.e., your salary will be higher by $X every year for the next 40 years). Also assume that the cost of capital associated with human capital is 10%.

Key Questions

1. Given the total cost that you will have spent on a Stern undergraduate education, how much of an annual salary increment would you need once you graduate to break even on your Stern education?
2. Given the remaining costs that you will have to spend to get a Stern degree, how much of an annual salary increment would you need once you graduate to break even on your Stern education?
3. Which number, i.e., the answer to (1 ) or the answer to (2) should drive your decision making today?
4. Now for the painful part. Let's assume that you don't believe that you can get this breakeven salary increment, given the state of the banking and consulting business, would you switch out of Stern to the state college next year?
5. Was your decision in (4) affected by the fact that you have already invested years and dollars at Stern? Why?