WHAT IS SUNK COST FALLACY AND WHY YOU SHOULD FORGET THE PAST
The film was dire. After an hour, I whispered to my wife: ‘Come on, let’s go home.’
She replied: ‘No way. We’re not throwing away $30.’
‘That’s no reason to stay,’ I protested. ‘The money’s already gone. This is the sunk cost fallacy at work – a thinking error!’
She glared at me as if she had just bitten off a piece of lemon. OK, I sometimes go overboard on the subject, itself an error called déformation professionnelle.
‘We have spent the $30 regardless of whether we stay or leave, so this factor should not play a role in our decision,’ I said, desperately trying to clarify the situation. Needless to say, I gave in in the end and sank back down in my seat.
The next day, I sat in a marketing meeting. Our advertising campaign had been running for four months and had not met even one of its goals. I was in favour of scrapping it. The advertising manager resisted, saying: ‘But we’ve invested so much money in it. If we stop now, it’ll all have been for nothing.’ Another victim of the sunk cost fallacy.
A friend struggled for years in a troubled relationship. His girlfriend cheated on him time and again. Each time, she came back repentant and begged for forgiveness. He explained it to me this way: ‘I’ve invested so much energy in the relationship, it would be wrong to throw it away.’ A classic case of the sunk cost fallacy.
The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy or love in something. This investment becomes a reason to carry on, even if we are dealing with a lost cause. The more we invest, the greater the sunk costs are, and the greater the urge to continue becomes.
Investors frequently fall victim to the sunk cost fallacy. Often they base their trading decisions on acquisition prices. ‘I lost so much money with this stock, I can’t sell it now,’ they say. This is irrational. The acquisition price should play no role. What counts is the stock’s future performance (and the future performance of alternative investments). Ironically, the more money a share loses, the more investors tend to stick by it.
This irrational behaviour is driven by a need for consistency. After all, consistency signifies credibility. We find contradictions abominable. If we decide to cancel a project halfway through, we create a contradiction: we admit that we once thought differently. Carrying on with a meaningless project delays this painful realisation and keeps up appearances.
Concorde is a prime example of a government deficit project. Even though both parties, Britain and France, had long known that the supersonic aircraft business would never work, they continued to invest enormous sums of money in it – if only to save face. Abandoning the project would have been tantamount to admitting defeat. The sunk cost fallacy is therefore often referred to as the Concorde effect. It leads to costly, even disastrous errors of judgement. The Americans extended their involvement in the Vietnam War because of this. Their thinking:
‘We’ve already sacrificed so much for this war; it’d be a mistake to give up now.’
‘We’ve come this far?…’
‘I’ve read so much of this book already?…’
‘But I’ve spent two years doing this course?…’
If you recognise any of these thought patterns, it shows that the sunk cost fallacy is at work in a corner of your brain.
Of course, there may be good reasons to continue investing in something to finalise it. But beware of doing so for the wrong reasons, such as to justify non-recoverable investments. Rational decision-making requires you to forget about the costs incurred to date. No matter how much you have already invested, only your assessment of the future costs and benefits counts.
It’ll-Get-Worse-Before-It-Gets-Better Fallacy – WHY ‘NO PAIN, NO GAIN’ SHOULD SET ALARM BELLS RINGING
Inability to Close Doors – WHY YOU SHOULD SET FIRE TO YOUR SHIPS
Endowment Effect – DON’T CLING TO THINGS
Effort Justification – HURTS SO GOOD
Loss Aversion – WHY EVIL STRIKES HARDER THAN GOOD
Outcome Bias – NEVER JUDGE A DECISION BY ITS OUTCOME
The above article is from the book The Art of Thinking Clearly by Rolf Dobelli. The article is only for educational and informative purposes to explain and understand cognitive biases. It is a great book, definitely worth a read!