sunk costs

How the Sunk Cost Fallacy Causes You to Make Bad Decisions

 

  • Sunk costs are a necessary part of business and life. Embracing them helps you spend money wisely and make the best decisions for your professional and personal paths.
  • The “endowment effect” is an evolutionary concept that causes people to overvalue something just because they own it.
  • The “sunk cost fallacy” causes people to become committed to something they’ve already spent money on, even when continuing to pursue it is no longer a rational decision.

 

Often when people hear the term “sunk cost,” they think of losing money. That’s a mindset we need to change.

Sunk cost is actually a necessary and rational part of business and life. Trying to avoid it is what leads to irrational decisions and wasted money. Embracing the concept can help you spend money more wisely and keep yourself on the best personal or professional path.

I’ll show you how.

What is sunk cost?

“Sunk cost” is an expense you’ve already incurred and cannot recover. These are in contrast to prospective costs, which are future expenses you may avoid if you change course.

Sunk costs, for example, may be:

  • The $1,200 fee I paid to cancel my family’s trip to Japan to avoid coronavirus.
  • College tuition, especially for a field you don’t or can’t pursue after graduation.
  • The money a startup invests in creating a product before pivoting.

We face sunk costs like these in both our professional and personal lives every day, and they can be beneficial. They become a problem only if we approach them with the wrong mindset.

The sunk cost fallacy

The problem with sunk costs is their tendency to convince us we have to forge forward because we’ve already invested too much to quit or change direction.

Say, for example, you’ve gone to law school and earned a law degree. Once you graduate, you decide you don’t want to be a lawyer but instead write a novel or return to school for marketing.

That shouldn’t be a bad thing.

The sunk cost fallacy is the mindset that you’ve just got to take on the burden of being a lawyer for the rest of your life because of the time and money you’ve sunk into law school. But why would you spend the rest of your life in a career you don’t like just because of three years in a particular pursuit?

Businesses can fall into this same trap. You might spend months and thousands or millions of dollars pursuing a product or project, and then realize it’s no longer the best path forward for you or the business. 

At that point, you can accept the investment as sunk cost, but many people are compelled to continue pursuing something solely because they’ve already put so much into it. Even if it won’t pay off best in the long run — even if you could earn above and beyond your sunk cost — you feel the need to stick to what you’ve started.

The endowment effect

This mindset about sunk costs comes from a psychological concept called the endowment effect. This is our tendency to overvalue something just because we own it.

Business Insider illustrated the endowment effect with an experiment in its series “Why Are We All So Stupid?” where host Sara Silverstein offered to buy people’s lottery tickets for two or more times their purchase price.

In the experiment, 78 percent of people refused to sell their tickets, concerned they risked selling a winning ticket. One man even replied, “Do you have $700 million?” demonstrating how highly he valued his ticket, as opposed to about $5 he’d sunk into buying it or $10 he could earn selling it to Sara.

Psychologists believe humans are hard-wired to this kind of loss aversion due to evolutionary pressures on losses and gains.

Consider that, for a hunter-gatherer society, the loss of a day’s food or water could mean consequences as severe as death. Gaining an extra day’s food is not very useful — traveling around with extra food on your back is actually a burden for a nomadic community. 

Evolutionarily, we learn that loss is greater than potential gain, so we overvalue what we already have.

This innate loss aversion leads to the sunk cost fallacy: We don’t want to lose what we already invested, created, or own, even if it’s no longer a rational pursuit.

The rational sunk cost mindset

You might be hard-wired emotionally to avoid sunk costs, but economically rational thinking can help you accept and embrace them.

Here’s a great example of that rationality: I started to work with someone last year on a website build with a $12,000 budget. About halfway in, when we reviewed what he was getting and why, it no longer made sense for his business.

He realized all he really needed was a simple website he could probably create through Wix or Squarespace and maintain himself — after he’d already spent about $6,000.

The loss-averse human might think you absolutely need to finish this project; you’ve already spent $6,000 on it! But he decided to stop and accept that sunk cost.

Here’s why: The prospective costs of stopping then were much lower than if he continued with the website we were building. He would have spent another $6,000 on the project, plus future maintenance costs. Stopping meant a $6,000 sunk cost, plus maybe $30 or so to set up the website he actually needed.

An economically rational mindset doesn’t see a wasted $6,000 on an unused website. It sees this client spent $6,000 to end up with a website that was perfect for him, instead of spending $12,000 plus future costs on a website that didn’t serve him at all.

You can apply this mindset to any sunk cost:

  • For my $1,200 sunk cost on the Japan trip, I gained peace of mind and safety for my family, plus a Cavoodle puppy I could buy with the $5,000 I didn’t spend on the trip.
  • For the sunk cost of a law degree, you might gain unique expertise and potential greater earning opportunities for pursuing a career you’re passionate about.
  • For the sunk cost of pivoting, a company might gain millions of dollars in sales pursuing a more fitting line of business.

Where are your sunk costs? 

I challenge you to look at the decisions you make in your business, career, and personal life. 

Ask yourself whether there’s anything you’re doing now simply because you’ve sunk time or money into it.

Are you pursuing anything you no longer have a rational reason to pursue?

Try to approach that thing with an economically rational mindset. Can you change course now and accept the sunk cost as a victory?

This is based on an episode of Fractal Marketing, the podcast for entrepreneurs who want to grow their company through smarter marketing. Subscribe and leave a review through Apple, Google, or wherever you listen to podcasts.

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