In a meeting at my previous company, we were discussing whether to continue working with software we had been struggling with for the past three years. Even after spending close to a million dollars and hundreds of labor hours, it was nowhere close to meeting our requirements. We had two options: ditch the software and go for a new solution or continue to spend time and money trying to make it work.
And guess what happened? We got sunk because of the sunk cost fallacy. Most present in the meeting felt that since we had already invested a lot of time, money and effort, ditching the software now would be an enormous waste of the resources spent. Welcome to the world of sunk costs!
Time and again, the sunk cost fallacy has played a decisive role both in innocuous situations and those with higher stakes. For example, you may continue to watch an irredeemable movie till the very end because of money spent on the ticket; or you may continue to work on a multi-billion dollar project even though the future prospects of business success are non-existent.
We get suckered into sunk costs when we let our future course of action be determined by past cost considerations even though the future benefits are questionable. Simply put, continuing a course of action to honor the resources already invested without careful consideration of the future, leads to the sunk cost fallacy.
On one hand it seems utterly irrational to do this; on the other hand, it seems like an intuitive course of action we’ve all taken at some point. Why is that? There are key psychological-behavioral factors that prevent us from thinking clearly about sunk costs. And like with most types of thinking problems, self-awareness is the first and the most important step to overcome these types of judgement errors.
Think of sunk costs as a gamble, such as a poker game or game of probability.
Let’s play a quick game. In this game, you have two option. Option 1 involves a bet, while Option 2 has a definite outcome. If you choose Option 1, you have an 80% chance of winning $4,000 and a 20% chance of winning nothing. If you choose Option 2, you are certain to win $3,000. Which one will you choose?
Now, let’s play another version of this game. This time, if you choose Option 1, you have an 80% chance of losing $4,000 and a 20% chance of losing nothing. If you choose Option 2, you are certain to lose $3,000. Which one will you choose now?
If you are like most “normal” people, you would have chosen the certain gain of $3000 in the first game and the bet in the second game. This brings us to one of the most important findings of Behavioral Finance: the Prospect Theory, for which Daniel Kahneman won a Nobel Prize in 2002.
According to Prospect Theory, we are more sensitive to losses than gains for a given amount. And because we are more sensitive to losses, we are likely to take greater risks when faced with losses than gains. For gains, we prefer certainty. For losses, we are okay with uncertainty.
And because we are so sensitive to losses, we hate to admit to ourselves and others that we have lost money or resources on a venture. So, we take the risk of spending more on it. When faced with an immediate and definite loss versus a long shot, we tend to favor the long-shot option for managing risk.
The long shot also makes for a better story. Have you ever come across a narrative where the protagonist embarks on a journey,and after several trials and tribulations gives up because it doesn’t make sense to continue? No. Quitters don’t make good stories or heroes. All of our inspiring stories are built around successes achieved in the face of what seems like unyielding obstacles. However, this only makes sense if the outcome is worth the effort expended.
How do we ensure we don’t succumb to our own fantasies? Appoint a Devil’s Advocate. In the 1600’s, the Vatican faced an interesting problem when canonizing. Because canonization was such a noble act, it was difficult to get opposing viewpoints to conduct a thorough due diligence. Who would voluntarily oppose the God’s Advocate; the one in favor of declaring sainthood?
So, the Vatican came up with an official position to take on the role of the opposition: the Devil’s Advocate. This not only made it okay for someone to oppose, but also gave the Vatican the official sanction to go and find opposing viewpoints.
By appointing a Devil’s Advocate, you assign someone to take on the role of an opposition, so all viewpoints are thought of, considered and discussed in a safe environment. The key idea is to take into account information that you may have otherwise failed to consider.
Sunk cost isn’t necessarily about quitting. It can help you persevere if seen from the right perspective.
In the 1880’s, Edison wasn’t making much money producing electric lamps. His manufacturing facility was not running at full capacity, because he was unable to sell his electric lamps in sufficient numbers. He hit upon a genius idea (remember, this is Edison!) to increase production and sell each extra lamp below the total cost of production.
He reasoned that the costs already sunk should not impact his decision to sink in more resources. The only thing that mattered was whether the additional future revenues exceeded the additional manufacturing costs. His decision to invest more in production capacity and sell extra lamps brought in additional revenues that exceeded the additional costs.
The next time you decide to continue a course of action, please stop to consider if you are being tricked by the sunk cost fallacy.
[Editor’s Note: Check out these related webinars, which can be taken for Continuing Legal Education (CLE) credit, or simply for practical and entertaining education for business owners, Accredited Investors, and their legal and financial advisors: Due Diligence Before Investing and Minimizing Risk When Terminating Employees.]
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Prasad Ramani, CFA, is the Founder and CEO of Syntoniq, a behavioral tech company that seeks to transform the financial services practice by productizing cutting-edge behavioral finance research into easily usable tech applications. Ramani launched Syntoniq in 2017 to address inconsistencies in traditional financial service models following 18+ years’ experience in Financial Services, Behavioral Finance,…
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