It is not uncommon to spend time, money, and energy on something and later be met with frustration when it doesn’t come to fruition. Perhaps you’re late into a college degree and are found wondering why you pursued it or continuing an unimaginative book simply because you started it and “want to see it through” or “already read so much of it.” These types of scenarios are often influenced by the Sunk Cost Fallacy. A cognitive bias that impacts our decision-making process solely based on our past investments. Understanding this fallacy and reacting accordingly can help enable us to make choices that better serve our objectives.
Understanding and Identifying the Sunk Cost Fallacy
The Sunk Cost Fallacy, also known as the Concord Fallacy, is a concept derived from game theory. The principle assumes that the more one invests in something, the harder it becomes to abandon it. This phenomenon stems from humans being loss-averse; “we are roughly 2.5 times more sensitive to losses than we are to gains of similar size.”1. This implies that the emotional impact of a financial loss is significantly stronger than that of a financial gain. This is particularly familiar to avid stock traders or gamblers. Losing sucks.
In a professional context, the Sunk Cost Fallacy is typically shown by continuing a project that consistently underperforms, solely because of the resources that have already been invested. So, when does one determine if enough is enough?
Before answering this question, the sunk cost has to be identified. The largest indicator would be noticing any emotional attachments. This can be shown by irrational decision-making, a fear of failure, or being too resistant to change. Defending a sunk cost is typically founded on one or more of these feelings. It’s important to remain logical and objective while navigating through turbulent waters.
How to Properly Assess a Sunk Cost
After identifying a sunk cost, it is important to conduct a comprehensive current and future state analysis. This is the most crucial step, which often fundamentally underperforms.
When rubbing your temples while studying linear algebra or rolling your eyes during a mundane book, people often begin to ask why. “Why” is the biggest question asked, and ironically, the answer is most likely to be forgotten. This is an extremely common question asked by leadership.
Now, there are two whys that must be answered:
- Why did we do this?
- Why should we continue (or cease) doing this?
Cognitive Biases within Sunk Costs
Starting with the former, a sunk cost began somewhere, often long ago, for a specific reason. Being able to efficiently recall and articulate the rationale behind the original decision is step one. There is a reason you, the team, or leadership wanted to pursue a specific avenue, but it is often forgotten months or years down the road when things change and memory fades.
In a study conducted by Sandeep Baliga and Jeffery Ely from Northwestern University, they investigated how memory constraints influence the decision-making process and affect cognitive biases2. They found that those who had memory constraints were more inclined to complete projects with a high sunk cost. This can be attributed to the optimism bias, justification based on the original investment, avoiding regret or thoughts of ‘wasting’ the principal, or a simple belief in the perceived value. Put generically, if you spend a significant amount of money and you don’t remember why, you are more likely to spend more money later. This finding is wildly concerning. There’s something to be said about not reinventing the wheel, but pushing forward with little to no recollection of the original reason is not a robust strategy.
Conversely, Baliga and Ely found that those with no memory constraint exhibited “Pro-rata Bias.” Which is when an individual is reluctant to continue investing in a project that has incurred high sunk costs. This shows that with complete information, educated MBA students (the subjects of the study) from Kellogg tried to avoid sunk costs with complete knowledge. Each avenue has a bias.
Which leads us to the second why: Why should we continue (or cease)?
When to Sink or Swim
It is important to conduct an entire analysis of the situation. Whether the sunk cost is a new skyscraper, annual donations to charity, a company initiative, or a consulting service, it needs to be seen in its totality. I’ll be writing a more detailed article on how to properly analyze a position in the future.
The rational economic decision is to solely consider the assessment of future costs and benefits, completely disregarding any sunk costs in the decision-making process. If the expected future benefits do not outweigh the associated future costs, it is rational to abandon ship.
Preventative Measures
- Centralized Decision-Making History Bank: Establish a centralized location of well-documented decisions. This practice will allow for easy referencing and promote informed decision-making.
- Setting Clear Objectives: Having measurable objectives will aid in assessing whether furthering investment into a project is justified.
- Regular Reviews: Furthermore, these objectives should be reviewed at designated intervals based on calendar dates or achievement milestones.
- Encourage Open Communication: A culture built around embracing change and encouraging open communication is a powerful way to identify, or prevent, a sunk cost.
- Pilot Projects: This is a great way to proactively gauge an investment within your organization’s unique risk appetite. This strategy can prevent the loss of large investments from full-scale implementations. With additional planning, the potential continuation of the project and its associated costs can be forecasted.
- Exit Strategy: Similar to the pilot projects, planning for failure is a great way of avoiding any major losses. Being able to readily pivot and utilize the learned knowledge elsewhere as a stepping stone is an indicator of a well-thought-out plan.
Conclusion
The Sunk Cost Fallacy can have significant implications in the workplace, influencing decisions while continually operating in the red. By understanding and identifying this fallacy, knowing when to jump ship, and implementing solutions to address it, businesses can make more rational and beneficial decisions. Viewing the company holistically can also help identify instances where the Sunk Cost Fallacy might serve another purpose, such as a loss leader, contributing to overall profitability.
- Klotz, Michelle. “Loss Aversion – Everything You Need to Know.” InsideBE, 28 June 2022, insidebe.com/articles/loss-aversion/#:~:text=Loss%20aversion%20defined&text=We%20are%20roughly%202.5%20times,the%20joy%20of%20finding%20%2450. ↩︎
- Baliga, Sandeep, and Jeffrey Ely. “Mnemonomics: The Sunk Cost Fallacy as A Memory Kludge.” Northwestern, 13 Mar. 2009, faculty.wcas.northwestern.edu/jel292/sunkcost-final.pdf. ↩︎
