The sunk cost effect is the ongoing investment of time, money and effort that an individual makes in any endeavor, even if rationally the results appear unpromising.
Why do you continue eating the food that you ordered in a restaurant, even if it doesn’t taste good? Have you noticed your friend still pining over a high school crush who is clearly not interested in them? Why do some investors continue investing in a stock even though it’s falling? We can see that our efforts are failing, but sometimes our behavior goes against rationality.
This is due to the behavioral fallacy known as the sunk cost effect.
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What is the sunk cost effect?
The sunk cost effect is the ongoing investment of time, money and effort that an individual makes in any endeavor, even if rationally the results appear unpromising. Why don’t we just stop? Well, this is easier said than done.
When any individual has already made an investment of time, money or effort, it becomes difficult to withdraw from the task. Rationally, an earlier investment of anything is not necessarily a guarantee of a future return. An error of judgement occurs when we fail to cut our losses—the sunk cost.
Sunk Cost Effect in Various Life Situations
Although an economic term, the sunk cost effect explains errors in judgement that we make in various life situations, like in our behavioral investments. Let’s go back to the previous examples that demonstrate behavioral investments.
You continue to eat food in the restaurant, even if it doesn’t taste good because you have already paid for the dish (monetary investment). It does not matter if you liked the food or not… you will pay the restaurant the full amount for the dish. There is also time investment. You must have travelled a certain distance to reach the restaurant, waited for a table, placed the order and waited for the dish to arrive. There is also some amount of effort put in dressing up to come to a restaurant and driving all the way. These investments make it difficult to acknowledge the sunk cost: the bad dish.
Your friend continues to pine over that girl since high school because of the efforts he has already put in it since he was in high school… that’s a long time!
To move on would mean he would have to restart everything with a new person. Again, in this scenario, the fallacy of your friend is the sunk cost. This is also why people hold on to long-term relationships, even if they know it might not work out.
Sunk cost effect in business and investments
We can clearly see the sunk cost effect in business investments. The fashion house Forever 21 continued expanding and building more and more stores worldwide, even when their sales dropped by 20% to 25%. In such a situation, a wise move would have been to honor the sunk cost and downsize on stores. Instead, it has now ceased operation in 40 countries and declared bankruptcy.
This behavior is also seen in stock market investors. You keep pumping in more money in the hopes of making a profit that will be able to cover your previous loss. Well, at least now we know why they say that you shouldn’t mix emotions with business!
As Warren Buffet says, “The most important thing to do if you find yourself in a hole is to stop digging.”
Why can’t we just cut our losses and move on?
Now that we know what the sunk cost effect is, it should be easier to identify it in our day-to-day behavior. The simplest method of beating this error of judgement is to simply stop investing when it’s not producing results. As the age-old proverb goes, ‘Why cry over spilt milk?’
But we still can’t seem to do it! Why?
The first reason is the prospect theory. According to this theory, people perceive the same amount of losses and gains in a different light. Losses have a higher degree of lost utility than the degree of utility one can derive from similar gains. This means that the same amount of losses will hurt more than an equal amount of gain.
For example, if a business is going through heavy losses, one must decide to either shut it down or continue. Shutting it down is a definite loss of money, time and effort. According to the prospect theory, people become risk-seeking when they are facing a definite loss. They will pump more money as a gamble to achieve a positive outcome.
If there is a positive outcome and the business starts making a profit, this has given them a higher utility than simply making profits from the beginning. They managed to rise up from a heavy loss, thereby giving higher satisfaction about the decision to continue investing. Maybe struggle is glorious in certain ways!
Another reason for the sunk cost effect is waste avoidance. We humans do not like the waste of resources (time, effort and money). When one decides to stop a project or behavior, that means that you have “wasted” your prior investment of time, money and effort put in that task. We humans do not like that!
Emotions and Sunk Cost
If the outcome of withdrawing from a task will produce higher anticipated regret, a person is more likely to fall for the sunk cost fallacy. Anxious people are more prone to fall prey to the sunk cost effect and may continue investing in a failed venture, whereas a depressed person will withdraw faster when seeing a failing situation because they will underestimate the likelihood of success. People high on neuroticism withdraw faster from a task and will start focusing on another less stressful task instead.
However, you won’t always fall victim to the sunk cost effect. We are, in the end, rational beings, or at least we try to believe so (awkward smile). We looked at various situations where ‘honoring’ the sunk cost makes us prey to certain decisions.
We, however, will not choose to honor sunk costs on every occasion. This is especially true in the case of insurance. Let’s say that you have taken home insurance and probably never used it. You are not going to burn your house down just so you can utilize your house insurance. At least, I hope you won’t! Similarly, unused health insurance does not mean that you take a bat and fracture your leg to “get your money’s worth”!
Although the sunk cost effect is a common behavioral fallacy, it won’t wreak complete havoc on your life!