Speculation is a way of choosing rather high risk investments to try to make a profit from a projected positive price movement. Speculation is different from investment in that speculators acquire much more risk and hope to realize their gains in short periods of time. Speculation is sometimes successful and sometimes unsuccessful; both outcomes can be seen in real estate over the last few years. Those who entered the real estate market in the year 2001 and sold within the next two to four years likely did exceedingly well; those who entered the real estate market in 2005 hoping to make a substantial amount of money by selling their properties today are likely facing substantial losses.
Some speculators hedge their positions to try to protect against substantial losses; in addition, some speculators will use leverage to try to maximize their profits in their investments. For instance, if I believe that oil will continue to go up in price, I may sell my current investments and take out a home equity loan and buy oil with those funds. As you can likely derive from that example, a combination of leverage and an incorrect speculative investment can lead to financial disaster. Some speculators make tremendous amounts of money; others lose the same. Be very careful when considering an investment that’s speculative!
A “sunk cost” is a cost that has already been paid for a project or investment–possibly a substantial one–and is very unlikely to be recovered. An example of this may be spending a substantial amount to repair a car that has multiple problems and may continue to incur substantial repair costs in the future. Rather than selling the vehicle or disposing of it and purchasing a different one with fewer problems, the owner may reason that, “If I get something else, everything I’ve invested has been wasted.” While the reasoning may technically be accurate, it’s not a relevant reason to continue to put money into the vehicle. The economically sound decision would be to start over, but many cannot because of the feeling that they will then lose whatever they’ve put in–when the reality is, they’ve already lost whatever they’ve put in.
The sunk cost fallacy can also move into other areas of life, such as time spent on a project (even a large project such as a college degree or job) or emotional investment into a relationship. There is a time when more investment into a losing proposition is simply a way to incur more losses, and it’s at that time that it becomes wiser to call it a day and head elsewhere.
Consider if what you’re getting yourself into deeper–whether it’s financial or otherwise–is a promising investment or a case of sunk costs. It’s not the easiest issue to deal with, but it may help you avoid larger losses in the future.
