The sunk cost fallacy is a standard thinking error that can profoundly affect decision-making. This psychological and economic concept refers to the tendency to improperly let previous investments of time, effort, or money influence current and future choices. When we factor “sunk costs” that can’t be recovered into our reasoning, it often leads to irrational conclusions and poor judgment.
In this article, we’ll define the sunk cost fallacy, unpack real-world examples of how it manifests, analyze its psychological mechanisms, discuss strategies to avoid the trap, and highlight the many benefits of recognizing when past investments should be ignored. Understanding this bias is critical to maximizing productivity, preventing further losses, and making objective choices focused on what lies ahead, whether in business, investing, trading, relationships, or other contexts.
Introduction to Behavioral Economics
Behavioral economics is a fascinating field combining psychology and economics insights to understand human decision-making better. Unlike traditional economics, which assumes people are perfectly rational, behavioral economics recognizes that real people are prone to cognitive biases that systematically influence their choices. The sunk cost fallacy is one of the most common and impactful of these irrational tendencies.
Defining the Sunk Cost Fallacy
The sunk cost fallacy describes our tendency to let previous investments of time, money, or effort influence our current decisions, even if these past investments are irrelevant to the decision. “sunk costs” refer to resources already committed and can’t be recovered. From a purely rational perspective, only a decision’s potential costs and benefits going forward should influence whether we proceed. However, we often let our past sacrifices or investments motivate continued engagement with a course of action, regardless of its current costs and benefits.
Historical Origins of the Concept
The idea of sunk costs dates back to the 19th-century economist John Stuart Mill. However, the specific phrase “sunk cost fallacy” was coined in the 1980s by economist Hal Arkes and psychologist Catherine Blumer. Through decision-making experiments, Arkes and Blumer identified the human tendency to allow sunk costs to affect their choices irrationally. Their findings launched decades of research unpacking this common quirk in human rationality.
Real-world Examples of the Sunk Cost Fallacy
The sunk cost fallacy manifests in diverse areas of life:
- Companies often continue failed projects in business after investing heavily in them, hoping to recoup their spent resources.
- In personal finance, individuals cling to investments that have lost money, wanting to avoid realizing the loss. Their goal is usually to get back to even and then sell.
- In relationships, people stay in unhappy partnerships to avoid “wasting” the years invested in the romance.
- Students pursuing a degree may feel compelled to continue, even if the program no longer suits them because they’ve already completed years of coursework and still want the diploma.
In all these cases, decisions should be made based on current and future costs and payoffs only. But sunk costs cause people to maintain commitments irrationally.
The Psychological Mechanisms Behind the Fallacy
Psychologists have identified several tendencies that contribute to the sunk cost fallacy:
- Loss aversion – We dislike losses far more than equivalent gains. Abandoning a sunk cost feels like realizing a loss.
- Commitment effects – We feel internally compelled to follow through on our past choices. To treat sunk costs as irrelevant undermines this commitment.
- Self-justification – We want to justify our past investments of resources rationally. Treating them as irrelevant would mean admitting we wasted precious time or money.
- Overoptimism – We tend to be unrealistically hopeful that further investment might pay off, allowing us to avoid admitting previous investments were unwise.
Why We Fall for the Sunk Cost Trap
Evolutionarily, being sensitive to sunk costs may have aided the survival of our ancestors. Cutting your losses on precious time and energy could prevent you from securing a vital resource. So, we evolved a tendency to persist. Of course, most modern sunk-cost situations lack the life-or-death stakes our ancestors faced, but the bias persists.
Implications in Business and Investment
The sunk cost fallacy erodes companies’ financial performance in various ways:
- Failing to cancel inefficient projects once their infeasibility is clear
- Retaining unproductive employees due to the training already invested in them
- Persisting with flawed product design features already created at great expense
- Refusing to sell depreciated investments, irrationally hoping their value will recover
Recognizing sunk cost bias is critical to maximizing economic returns.
Implications in Investing and the Stock Market
The sunk cost fallacy can lead to suboptimal decision-making, especially in investing and the stock market. Here are some implications of the sunk cost fallacy in this context:
- Holding onto Losing Stocks: Investors might hold onto underperforming stocks because they want to “break-even” rather than recognizing the loss and reallocating resources to more promising investments.
- Overcommitting to a Strategy: An investor might continue pouring money into a failing strategy simply because they’ve invested so much rather than re-evaluating its future potential.
- Ignoring New Information: If an investor has heavily committed to a stock or strategy, they might ignore new negative information about that investment, hoping that things will turn around.
- Reduced Diversification: An investor might become overly focused on a few investments where they’ve experienced losses, trying to recover those losses and neglecting the broader diversification of their portfolio.
- Emotional Stress: The desire to recover sunk costs can lead to emotional distress, further cloud judgment, and poor decision-making.
- Opportunity Costs: Investors might miss out on other, more lucrative investment opportunities by focusing on recovering sunk costs.
- Increased Risk: Trying to recover sunk costs might lead investors to take on additional risks, hoping for higher returns to offset previous losses.
- Chasing Past Performance: Investors might pour more money into funds or stocks that have recently underperformed, hoping to return to their previous high performance, even if the fundamentals don’t support such a rebound.
- Overtrading: In an attempt to recover losses, an investor might engage in frequent trading, leading to higher transaction costs and potential tax implications.
- Confirmation Bias: The sunk cost fallacy can be compounded by confirmation bias, where investors seek information confirming their beliefs or decisions, further entrenching them in their current position.
- Reluctance to Admit Mistakes: The sunk cost fallacy can make it difficult for investors to admit they made a wrong decision, leading to prolonged poor investment choices.
- Inefficient Allocation of Capital: From a broader market perspective, if many investors are holding onto underperforming assets due to the sunk cost fallacy, it can lead to an inefficient allocation of capital in the market.
To avoid the pitfalls of the sunk cost fallacy, investors should strive for objective decision-making, regularly review their investment thesis, and be willing to adapt based on new information. It’s also beneficial to be aware of one’s emotional biases and seek advice from financial professionals or trusted peers.
The Sunk Cost Fallacy in Personal Relationships
Romantic relationships are another area where the sunk cost fallacy causes people to persist with partners or commitments that are no longer beneficial:
- Staying in an unhappy marriage because of the many years already invested
- Refusing to end an unhealthy relationship after having already put in substantial effort to make it work
- Feeling unable to back out of a wedding after spending huge sums booking venues, catering, etc.
As with business decisions, relational choices will be most rational if sunk costs are ignored.
Strategies to Overcome the Sunk Cost Bias
How can we make decisions rationally in the face of sunk costs?
- Reframe – Don’t think of past investments as losses if abandoned. Instead, frame them as information-gathering or learning experiences.
- Focus forward – Evaluate the current and future costs and benefits only, ignoring sunk investments. Would you make the same choice if starting fresh?
- View yourself as advising others – Imagine advising a friend on the decision as an outsider. This reduces your psychological commitment.
- Trust predetermined stopping points – Establish rules dictating when you will abort a failing investment and follow them.
The Benefits of Recognizing and Avoiding the Fallacy
Making rational decisions unclouded by past sunk costs has many advantages:
- Avoiding further losses on unwise projects or investments
- Cutting ties with commitments that are no longer beneficial
- Reducing future regret when past choices lead to failure
- Unlocking wasted resources that can be utilized more productively elsewhere
- Learning when to persist versus when to pivot based on new information
Making Rational Decisions in the Face of Sunk Costs
The sunk cost fallacy is deeply ingrained in human thinking. However, being aware of this bias and intentionally shifting perspective is crucial. When evaluating decisions based on past investments, ignore those sunk costs and weigh the choice objectively. With practice, we can all know when it makes sense to cut our losses and move forward.
Key Takeaways
- The sunk cost fallacy makes us irrationally factor past investments into current decisions. Only future costs and benefits should guide choices.
- Psychologists and economists identified this thinking error. It manifests across personal finance, business, and relationships.
- Loss aversion, commitment effects, self-justification, and over-optimism contribute to the sunk cost bias.
- Reframing sunk costs, ignoring them, and predetermined stop points help avoid the trap.
- Making objective decisions produces better outcomes. We learn to persist or pivot based on new data.
Conclusion
Behavioral research shows we are prone to the sunk cost fallacy – letting prior time, money, or effort wrongly influence our current actions. This often leads to further losses and missed opportunities. But by recognizing when we are irrationally clinging to past investments, we can intentionally shift our perspective to the future payoffs. This allows more rational choices based on the actual merits of various options, not our psychological attachments to previous efforts. We can override this subtle but destructive bias in decision-making with self-awareness and practice.