The sunk cost fallacy

The one thing that stuck with me from my biz module back in NTU was the concept of sunk cost, and the sunk cost trap.In economic/business terms, a sunk cost is a cost that has already been incurred and thus cannot be recovered. And the sunk cost trap is about the psychological need to protect these past choices (and protect our prior monetary/emotional commitment). Here are some examples of this sunk cost fallacy.

 

1. Imagine you go see a movie which costs $10 for a ticket. When you open your wallet or purse you realize you’ve lost a $10 bill. Would you still buy a ticket? You probably would. Only 12 percent of subjects said they wouldn’t. Now, imagine you go to see the movie and pay $10 for a ticket, but right before you hand it over to get inside you realize you’ve lost it. Would you go back and buy another ticket? Maybe, but it would hurt a lot more. In the experiment, 54 percent of people said they would not. The situation is the exact same. You lose $10 and then must pay $10 to see the movie, but the second scenario feels different. It seems as if the money was assigned to a specific purpose and then lost, and loss sucks (www.youarenotsosmart.com)

 

2. On the same example of movie ticket, let’s assume you have bought a non-refundable ticket for the evening. When evening arrives, you realise that you no longer feel like watching the movie – but you still drag yourself to the theater because you have already paid for the tickets. It doesn’t really make sense because the money has already been spent. The real choice was a) be happy by staying at home b) put yourself in a worse mood by going for the movie.

 

3. Now imagine you are a business owner who have invested a substantial amount to build a factory. Due to unforeseen circumstances, the company will need to pump in more money to complete the construction. It is easy to justify the additional capital because without it, the initial investment and plans would go to waste. However, the more important question is if the future income will justify that additional capital. If not, the loss would simply be bigger

 

4. Of course, the same trap often happens in investment decisions. Time to time, I come across investors who would adamantly stick to their initial investment choices so as to avoid locking in losses (sometimes, even when it is just paper loss). This is in part due to the emotional commitment to the investment itself. But truth is, If you are holding on to a sinking stock, it would be much better to get out fast and get into another asset class/stock which is better positioned for recovery.

 

5. The sunk cost fallacy also happens in relationship. Imagine this: You are now 30 years old and have invested 7 years of your life to the man/woman you used to love. Both of you have gone through various experiences together and have invested much time and emotions to each other. Then at some point, you start getting the feeling that he/she may not the one you want to spend the rest of your life with… But you stay in the relationship anyway. Because of the aversion of loss – you do not wish for that 7 years to ‘go to waste’. Though in reality, what is really at stake is not the 7 years that have passed but the 50 years ahead.

It’s not easy to avoid the sunk cost trap.., But if we are able to, we would consistently be making better financial, business and life choices for ourselves and hence, likely to be much happier 😉