Have you ever made a decision based on the fact that you don't want your money to go to waste? If you answered yes to this question, then you've personally experienced the fallacy of sunk cost. The more time, money, and effort you invest in something, the harder it is to let that something go. The fallacy of sunk cost happens when you let your emotional connection to investments dictate current and future decisions.
Defining the Fallacy of Sunk Cost
A sunk cost can be defined as money that has been expensed and cannot be refunded or recovered. Keeping this is mind, we can further define the fallacy of sunk cost. When someone uses sunk costs rather than future costs and profits to decide whether or not to continue an investment or activity, the fallacy of sunk cost is at play.
The sunk cost fallacy typically causes an escalation of commitment or commitment bias. This is present when an individual or business continues investing their assets, such as time and money, into an activity that they wouldn't normally continue because of the fallacy of sunk cost. The larger the sunk cost, the more difficult it is for the person or business to pull out of the investment, regardless of the lack of profitable return. This continuous negative cycle can sometimes be referred to as throwing good money after bad.
Psychology of Sunk Cost
Studies suggest that individuals and businesses allow sunk costs to dictate their behavior and decisions because they are in denial that their initial investment may not ever pay off. They make a mental decision that their investment was a smart choice and will pay off in the long run. Furthermore, these studies show that the individuals who made the initial investment feel personally responsible for the sunk cost and are therefore more likely to continue investing to try to reverse the loss.
Researchers Daniel Kahneman and Amos Tversky stated that individuals are subject to the fallacy of sunk cost because of loss aversion. Loss aversion means that the desire to avoid a loss is greater than the desire to make a profit or gain. When individuals or businesses choose to continue an activity because of the sunk cost, they are theoretically avoiding the loss or at least the acceptance of the loss.
Psychologists toss around terms such as plausible deniability and cognitive dissonance as the driving factors behind the fallacy of sunk costs. Essentially, the continuation of a behavior that is not a smart economic move is simply a means to justify one's previous decisions and avoid accepting the fact that a mistake was made in the first place.
Humans have many emotions that can cause them to fall into the fallacy of sunk costs trap. For example, one could be attempting to correct the term mentioned previously, cognitive dissonance. This is known as a mental disconnection between investing in something and not receiving the planned return on investment. Other emotions that cause it could be an instinctive reaction to regret or merely a refusal to accept that their money and resources were wasted.
From an outsider's perspective, these decisions may seem to be completely irrational. However, individuals and businesses that are personally experiencing this fallacy are just striving to feel emotionally satisfied through attempts at recovering their sunk cost. Furthermore, this fallacy can also occur even if the individual did not personally make the decision behind the sunk cost. Many people feel the need to recover a sunk cost made by someone else just as much as they do their own loss. For example, if an individual gifts you an expensive concert ticket, you will feel obligated to go so that the ticket doesn't go to waste just like you would if you had purchased the ticket for yourself.
The Problem with Sunk Cost
The problem with the fallacy of sunk cost is that an individual or business is making an irrational decision based on sunk costs which is considered impertinent data. Given that the data is irrelevant, this action is unlikely to provide a beneficial outcome for the person or business. Further investing in something that has already resulted in sunk costs is most likely going to result in more sunk costs because it feeds the continuous cycle of investing and losing in the same activity.
The escalation of commitment to a previous investment can also create an opportunity cost. The individual or business might get so caught up in investing in their previous activity that they miss out on future profits and growth.
Examples of Sunk Cost
If you had the choice between spending more money or having more fun, which would you choose? While you would probably think the obvious answer is having more fun, a research project performed by Ohio University suggests otherwise.
Researchers asked college students to pretend that they accidentally purchased a $50 skip trip and a $100 ski trip for the same weekend. They were told that they would have a lot more fun on the $50 skip trip, but could only choose one trip and neither expense was recoverable. The majority of the students chose the $100 trip because it was a larger sunk cost than the $50 trip. The size of the sunk cost seemed to be more important than the actual enjoyment of the trip.
Another example of the fallacy of sunk cost can be seen in employee performance reviews. A study conducted by Purdue University revealed that an escalation of commitment is widely prevalent in performance reviews.
This study viewed supervisors' evaluations of three sections of employees:
- Employees that they did not assist in hiring
- Employees in which they were involved in the hiring process and voted yes for the hire
- Employees in which they were involved in the hiring process but voted no for the hire
The reviews that the supervisors gave were proven to be affected by the supervisors' roles in the hiring process. When the supervisors approved the hiring, the employees received a high rating giving an example of a positive escalation bias. When the supervisors disagreed with the hire, the employee received a lower rating, demonstrating a negative escalation bias.
Now let's look at one last example of a business project that went south. The Concorde project consisted of a group individuals who set out to build a supersonic airliner. Although the project had financing struggles, the team did not want to give up. The British and French governments continued to fund the project even though it was not providing any benefit to the economy. For this reason, another term for the sunk cost fallacy is the Concorde Fallacy and the project is now known as the Anglo/French financial misadventure.
How to Overcome the Fallacy of Sunk Cost
If you've every used the phrase "We've already spent too much money on this" or "We just need to plan a little better," then you've probably fallen into the trap of the fallacy of sunk cost. It is important to realize and accept the fact that if something is not working out, then regardless of the amount of money invested in it, it may be time to call it quits and move on. Easier said than done, right? While moving on from sunk costs can be difficult, it is such an important step to take so that you and/or your business can truly thrive.
The following are a few steps you can take to overcome the emotions behind the sunk cost fallacy:
- Don't forget to create and focus on your long term goals
- Be aware of reality as well as your goals
- Keep note of any investments, both time and money, that have been made and be ready to accept the losses if the investments don't work out
- Place the facts above your dreams and external pressure
- Remember that not everything goes as planned and failure happens
- Keep your mind in the present
- Use your mistakes to learn and grow
Accepting temporary defeat and acknowledging that a mistake has been made is never easy for an individual or business to admit; however, accepting these facts is a great way to get your life and/or business turned around and headed in the right direction. Once you begin looking at all of your options and making smarter, more educated decisions, the natural tendency to use both past time and financial investments as a means for future decisions will become less common.
If you're reading this and realizing that you have fallen into the fallacy of sunk cost trap, you're not alone. Are you realizing that you need some financial assistance to get you or your business turned around?