The Sunk Cost Fallacy is a cognitive bias in which people make decisions (time, money, effort/resources) based on past costs, even when those costs are no longer relevant. In other words, people continue to invest in a failing project or venture because they have already invested time, money, or effort into it.
A sunk cost is an irretrievable cost. It is a cost that we cannot get back. For example, if spending $500 000 USD on advertising, we cannot reclaim this money from advertising agencies.
The Sunk Cost Fallacy was first coined by Richard Thaler in his 1980 paper, “Toward a positive theory of consumer choice.” Thaler argued that the sunk cost fallacy is a common mistake that people make because they have a difficult time letting go of their losses.
Example
- Personal Expenditures
Imagine that you buy a ticket to a concert that you are not really looking forward to. You have already paid for the ticket, so you feel obligated to go even though you would rather stay home. This is an example of the sunk cost fallacy because you are making a decision based on the past cost of the ticket, even though that cost is no longer relevant. - Failing Products
The Sunk Cost Fallacy can lead to people making bad decisions. For example, a company might continue to invest in a failing product because they have already spent a lot of money on it. This could lead to the company losing even more money in the long run. - Relationships
Another example is spending several years in a relationship. If the relationship derails and is no longer working, people tend to stay mainly because of the sunken costs (all the time and effort that went into it). They do this despite it not working, while it leads to their unhappiness and even when it is not likely to get better (even with through therapy or other similar measures). This could lead to further unhappiness, a sense of lost time and resentment. A better move in such a scenario, would often be to let go, cut your losses and move on. - Education
Let’s say you spend six years gaining a medical degree to become a doctor. The investment in education is now a sunk cost (in terms of time, effort and money). However, once graduated, you find that you do not like the profession and would like to do something different, like open up a restaurant. If you wish to honor the sunk costs of education, you will continue to work as a doctor, despite not enjoying it. However, if you ignore the sunk costs, you are free to make a choice about which career you would like to pursue and how you would like to spend your time.
It is important to be aware of the Sunk Cost Fallacy so that you can avoid making bad decisions. When making a decision, it is important to focus on the future costs and benefits, not on the past costs.
Decision Making at the Margin
Consider what the marginal benefits and marginal costs of deciding to continue with investment. When making decisions at the margin, we discount any sunk costs, since these historic costs do not affect future marginal benefits and marginal costs.
Like the saying “it is no use crying over spilt milk.” Once the damage is done, we cannot change that fact. We need to rather focus on the things we can do something about. What is the best decision/action at the present moment (knowing what we now know)?
Tips for Avoiding the Sunk Cost Fallacy
- Acknowledge the sunk cost
The first step to avoiding the Sunk Cost Fallacy is to acknowledge that you have made a sunk cost. Once you have acknowledged the sunk cost, you can start to think about the future costs and benefits of your decision. - Consider the opportunity cost
The opportunity cost is the cost of the next best alternative. When you are making a decision, it is important to consider the opportunity cost of your decision. For example, if you are considering buying a new car, you should consider the opportunity cost of buying a new car, which is the cost of the next best alternative, such as buying a used car or keeping your current car. - Make a decision based on the future costs and benefits
Once you have considered the sunk cost and the opportunity cost, you can make a decision based on the future costs and benefits of your decision.
Related concepts
- Mental Accounting, a term coined by Richard Thaler, states that we hold different views of goods depending on how we received it. If we pay $100 for a ticket, we feel a strong attachment to it and a commitment to use it. However, if we receive the ticket for free, we are more likely to ignore its market value, and if we fall sick or do not feel like it, more easily decide which option gives us most utility: staying at home or using the ticket.
- Prospect Theory says that carriers of value are changes in wealth or welfare, rather than final outcomes. It also posits that “Losses loom larger than gains.” This helps us understand why we may not want to sell a house at a loss, even if that would make us better off under the circumstances of that situation.
- The book Nudge: Improving Decisions About Health, Wealth, and Happiness”(2008) by Richard Thaler
- Thinking, Fast and Slow (2011) by Daniel Kahneman, also see the below section on Cognitive Biases
- Predictably Irrational: The Hidden Forces That Shape Our Decisions (2008) by Dan Ariely
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