Fred Wilson, partner at Union Square Ventures and investor in most networks we know and love (Twitter, Tumblr, Etsy, Kickstarter), has a great post on sunk costs this week. It is a must read. My favorite part is –
‘This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we’ll get our money back or even a return on it.
Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.’
This seemingly simple insight is what relevant costs in Microeconomics is all about. When making a decision on new investment, don’t consider past investment. It isn’t relevant. What is relevant is the return you are going to get on your current investment. What about the past investment then? Well, you should have thought that through carefully when you were making that decision. Nothing can be done about it now. As humans, we hate the idea of loss. And, the relevant costs concept attempts to guard us against exactly that.
We don’t have to be venture capitalists to have experienced relevant costs. We have seen relevant costs play in bad relationships that we held onto because of an abundance of memories, we’ve seen ourselves follow on on bad bets in poker, and we’ve probably made many a bad decision in attempting to stick with an existing investment hoping it’ll sort itself out – despite the signs telling us otherwise.
Relevant costs essentially give us a great guideline for decision making – make decisions looking forward based on today’s data. Yesterday’s investments don’t matter.
We all know that we can’t drive using the rear view mirror. Yet, as Fred points, out, we tend to do it more often than not. Microeconomics provides us with tools to think about decisions and guard against being predictably irrational.
As with all good things, it is up to us to put them to good use.
A Learning a Day 