logo

What is Sunk Cost Fallacy

What is Sunk Cost Fallacy

Level 4 - Thinking - Investment Pyschology

5 min read  ·  1739 views

Dyce Lim, Research Analyst

Dec 30 2022

Reviewed By Charlie Yuan Ting Jing, CFA, CQF


Definition of Sunk Cost

Sunk cost, also known as the retrospective cost is a cost that has already been incurred and cannot be recovered. This type of cost is often taken into account when making decisions about whether to continue investing in a project or pursue a certain course of action. Theoretically, sunk cost should not be relevant to your future decision. However, this can be difficult to do in practice as humans are often emotionally attached to sunk costs and have a difficult time letting go of the previously invested time, effort or financial resources.

The Sunk Cost Fallacy

Sunk cost fallacy is a cognitive bias that occurs when we make decisions based on sunk costs. To explain further, it is a logical error that occurs when people think about the costs and benefits of future actions in terms of past costs that have already been incurred, and not the opportunity cost of alternative actions. When we fall prey to the sunk cost fallacy, we make irrational decisions that are against our best interest, as we may be reluctant to abandon something if we have invested a lot of time or money in it, even if it is no longer the best option.

A famous example of the sunk cost fallacy: The Concorde Fallacy. The Concorde Fallacy gets its name from the ill-fated Concorde supersonic passenger jet in 1956. Initially, it was estimated that it would cost around $100 million to develop the Concorde. However, as the project progressed, it became increasingly more expensive. Even though this was the case, the governments continued to invest because they had already sunk a lot of money into the project. The Concorde never became a profitable project, and the aircraft was taken out of service after less than thirty years. The fallacy is named after the Concorde because the decision to develop and build the aircraft was based on the false belief that once the decision was made, it could not be undone.

Opportunity Cost VS Sunk Cost

Opportunity cost and sunk cost are two important economic concepts in the decision-making process as they can help you assess whether or not to move forward with a project. In business decisions, organizations often focus too much on sunk Costs, ignoring the opportunity Costs. To put it simply, opportunity cost is the value of the next best alternative

To make the best decision, we must weigh the opportunity cost against the sunk cost. What are the alternatives? What are the potential benefits and risks associated with each option? These are some of the questions we can ask ourselves to avoid making decisions solely based on sunk cost. If the opportunity cost is greater than the sunk cost, then it makes sense to move forward with the new option.

How Does Sunk Cost Fallacy Work

There are a few psychological factors at play as to why we fall victim to the sunk cost fallacy. Here are a few psychological factors that explain why the sunk cost effect might occur:

  1. Loss Aversion: People's tendency to avoid losses over acquiring gains. With the sunk cost fallacy, loss aversion leads us to hold on to an underperformed investment that is not working out, simply because we are afraid of losing what we have already invested.
  2. Waste Avoidance: People's tendency to follow through on a decision to avoid negative feelings of wastefulness. We may want to avoid wasting unrecoverable resources. However, sunk cost fallacy would cause greater wasteful spending as we continue to throw good money after bad.
  3. Commitment Bias: People's tendency to stick with the initial behaviours and beliefs, simply because that is what we’re comfortable with. Change can be scary, so we tend to avoid it even when it would be beneficial. Committing to something can also lead to a feeling of responsibility for seeing it through, even if it is not in our best interest to do so.

Is Sunk Cost Fallacy really bad for future decisions?

Generally, Yes. When we allow the sunk cost fallacy to interrupt our decisions, it can lead us to suboptimal decisions as we are too focused on the costs we have already incurred instead of the potential benefits of a different course of action. Therefore, it is a mistake in reasoning when deciding whether to continue with the activity.

Assume you spend RM20 on a movie. Shortly after 30 minutes into watching the movie, you realize that you don't enjoy it. Would you continue to waste your time on boring movies?

A majority of people would choose to continue watching since they have invested 30 minutes of their time and money into it. Although it may be boring, the loss of leaving the cinema seems greater. However, economists suggest that rational people would not consider sunk costs in their decisions as the money has already been spent. Your decision at that time should be based solely on whether you want to continue watching the movie. In fact, if we leave the cinema after realizing it was a boring movie, we are only wasting 30 minutes while reducing the opportunity cost for other more meaningful events. However, if we fall prey to the sunk cost fallacy, we end up spending more of our valuable time just to make up the cost of the ticket.

Based on the above, this suggests that the sunk cost fallacy can hinder you from comprehending what the best decision is and make us overemphasize the loss of an unrecoverable amount.

Where This Sunk Cost Fallacy Occurs

The sunk cost fallacy can be seen in many other areas of life:

  • Carry on with an unhappy relationship because you've been dating for 10 years
  • Wasting your time sitting through a boring movie because you've already paid for the ticket.
  • Retaining an incompetent employee on staff rather than replacing them because the company has already invested tens of thousands of dollars in training them.
  • Holding on to the investment despite a clear change in the narrative and performance of the company because you've already invested so much.
  • Overeating to make the money spent worthwhile.
  • Continue the career path that you dislike after a large sum of money and time have been spent on your degree to prevent all that from "going to waste".

Sunk Cost Fallacy in Investment

In the context of investing, the sunk cost fallacy can lead investors to hold onto investments that are missing expectations, even if it would be more rational to sell and invest the resources elsewhere. Below are some examples of sunk cost fallacy in investment:

  1. Continuing to hold onto a losing stock: An investor may be unwilling to sell a losing stock due to the sense of loss that they may feel if they sell at a loss. They would not want to “waste” the amount that they’ve previously invested. They think the stock price will eventually turn around.
  2. Refuse to sell a property at loss: An investor may be unwilling to sell their property at a loss because they don’t want to admit defeat and sell at a lower price than they paid even if the market condition suggests it is unlikely to increase in value.

The Bottom Line

As we mentioned in the examples, we can see that The sunk cost fallacy is exhibited in a variety of scenarios in our lives. Way too often, sunk cost fallacy clouds judgment and keeps us pursuing something that makes us worse off, thereby digging a bigger hole. We tend to underestimate the importance of opportunity costs. This means that we often fail to consider the cost of not doing something (e.g. the opportunity cost of continuing to invest in a failing project). The sunk cost fallacy can be a difficult bias to overcome, but it is important to remember that the past is irrelevant. What's gone is gone, there’s nothing you can do to recapture the loss. The only thing that matters is the present and the future.

Author


speaker profile

This article is written by Dyce Lim, Research Analyst

Dyce is a research analyst in TED Optimus, tasked with researching and performing analysis on companies. She holds a Bachelor of Science in Financial Analysis Degree from Sunway University. During her time at Sunway University, She has participated in the CFA Research Challenge 2019/2020 and won second runner-up in the event. She is also a CFA Level 2 candidate. She is an in-house author of TED Optimus.

Disclosure


Information and articles provided by The Trade Wizard (TTW) are for general knowledge and educational purposes only. They do not constitute an offer, recommendation or solicitation to enter into any transaction. This article has not been prepared for any particular person or class of persons and it has been prepared without regard to the specific investment or insurance objectives, financial situation or particular needs of any person. You should seek advice from a licensed or an exempt financial adviser on the suitability of a product or investment for you. In the event that you choose not to seek advice from a licensed or an exempt financial adviser, you are fully responsible for your investment decision, including whether the investment is suitable for you.

To the best of our knowledge, all content is accurate as of the date posted. The opinions expressed are the author’s alone and have not been provided, approved, or otherwise endorsed by our partners. This commentary may contain forward-looking statements, which by definition are uncertain. Actual results could differ materially from our forecasts or estimations. The Trade Wizard (TTW) will not be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in this article.

The author(s) may have a beneficial position in the shares mentioned above (if any) either through stock ownership, or other derivatives. He(She) wrote this article on a personal capacity, and expressed personal opinions. He(She) is not receiving compensation from the listed company covered in this article (other than from The Trade Wizard (TTW)). He(She) has no business relationship with any company whose stock is mentioned in this article.

Table of Contents

  1. Definition of Sunk Cost
  2. The Sunk Cost Fallacy
  3. Opportunity Cost VS Sunk Cost
  4. How Does Sunk Cost Fallacy Work
  5. Is Sunk Cost Fallacy really bad for future decisions?
  6. Where This Sunk Cost Fallacy Occurs
  7. Sunk Cost Fallacy in Investment
  8. The Bottom Line