Sunk costs are expensive. Not necessarily from a financial viewpoint, but when considering your time and energy (arguably, more valuable). This post looks at some examples of how sunk cost fallacy affects our human decision processes. And of course, it would be incomplete without mentioning the most famous example of all: the Concorde effect (yes, the aeroplane).
One of the best examples of the sunk cost fallacy is Concorde. Even though both parties, the British and French governments, had known for a long time that the supersonic airline business was never going to work, they continued to invest gigantic sums of money into it. Instead of admitting defeat, they continued funding a government deficit project to save face.
If you’ve ever heard of the concorde fallacy or concorde effects, this is it – the sunk cost fallacy. The term was coined by evolutionary biologists as a metaphor for when lower animals or humans defend an investment, policy, business or nest – when that defence costs more than abandonment and an alternative. It leads to costly and often calamitous errors in judgement.
Shakespeare says it somewhat more poetically:
The better part of valor is discretion
Our fear of regret can make us behave irrationally. To avoid deviating too much from the crowd, we tend to act conservatively. But we need to try be more rational in our assessment of efficiency and profitability when making decisions, and not be influenced by the sunk cost effect that is more akin to loss aversion.
You might recall the disposition effect, where we sell shares that have made a profit, but hold onto shares that have made a loss. While this is loss aversion in play, there’s also an element of sunk cost fallacy because we often base our trading decisions on acquisition prices. This isn’t the best way to do it. What matters is the expected future performance of that stock compared to other alternative investments. Yet ironically, the more we feel we’ve lost on that share (based on it’s acquisition price), the more we hold onto it. (Extrapolate this into a corporate finance example.)
Our fear of regret (and the endowment effect) also prevents us from throwing away things we no longer need. The sunk cost fallacy is telling us that we paid money for the items and thus shouldn’t throw them away and admit it was a bad purchase decision. And then our avoidance of regret reminds us that we’ll experience remorse in the unlikely event that we might end up needing that item in the future.
Listen to a 6 minute interview with Dr Gizelle Willows and Simon Brown on the sunk cost fallacy and how to avoid making decisions based on the past.
Dr Gizelle Willows
PhD and NRF-rating in Behavioural Finance
You have hit the mark. I like this thought, I completely agree with you.