Definition
The Sunk Cost Fallacy refers to the tendency to continue investing in a project or decision based on the cumulative prior investment (sunk costs) despite new evidence suggesting that the cost, starting today, of continuing the decision outweighs the expected benefit. Sunk costs are costs that have already been incurred and cannot be recovered. The fallacy lies in letting them affect future decision-making when ideally, decisions should be based solely on future expected returns.
Key Takeaways
- The Sunk Cost Fallacy refers to a cognitive bias where individuals or businesses continue a behavior or endeavor due to previously invested resources (time, money, or effort), despite the costs outweighing the benefits.
- This fallacy can lead to wastage of resources and suboptimal decision-making as it keeps individuals or entities from considering the potential return based on future value. Thus, it promotes a focus on past cost rather external factors that are more relevant to the decision.
- One key way to overcome the sunk cost fallacy is by making decisions based on future potential, rather than past investments. This involves treating all costs that can’t be recouped as irrelevant for future decision-making.
Importance
The Sunk Cost Fallacy is an important concept in finance because it deals with the flawed reasoning that further investments (of time, money, or resources) should be made on an endeavor because of the past costs already incurred, instead of looking forward to the future benefits.
This fallacy can lead to poor decision making and inefficient allocation of resources.
It stems from our inherent loss-aversion bias where individuals or businesses continue sinking more resources into losing propositions simply because they have already invested in it, rather than cutting their losses.
Understanding this fallacy is critical to making informed decisions that focus on the potential future returns rather than the irretrievable costs already expended.
Explanation
The Sunk Cost Fallacy refers to the misconception that investments, usually monetary, require an individual or business to remain committed to an undertaking. The principle primarily serves as a warning against justifying increased investment in a decision, based on the cumulative prior investment (“sunk costs”), while disregarding the prospective costs.
It is a psychological trap that influences individuals to stick with a less beneficial decision due to the costs they’ve already incurred. The purpose of understanding the concept of the Sunk Cost Fallacy is to improve decision-making in the spheres of business, finance, and personal investment.
Economically rational decisions should not consider sunk costs, as they are irretrievable. Recognizing the fallacy aids in making decisions based purely on current circumstances and future benefits rather than past losses.
It is a powerful tool used to guide businessmen and investors away from unprofitable ventures, promoting strategic financial planning.
Examples of Sunk Cost Fallacy
Gym Membership: A person buys an annual gym membership to save money compared to the monthly membership cost. However, after a few months, they stop going. Despite not using the services anymore, the person maintains the subscription for the entire year thinking they might start going again. They don’t want the feeling that they’ve “wasted” the money, even though the cost is already sunk and not going can’t recover that money.
Dining Out: Imagine a scenario where a person pays for a large, expensive meal at a restaurant. As they begin to eat, they soon realize that they’re not enjoying the meal or it’s too much food, yet they persist on eating because they’ve already paid for it and don’t want to “waste” their money. The fallacy lies in considering the money already spent (sunk cost) rather than their present situation and potential discomfort or health issue from overeating.
Real Estate Investments: A real estate investor buys a property planning to renovate and resell it at a profit. However, the property turns out to need more repairs than initially expected, leading to more investment. Instead of cutting their losses and selling the property as it is, the investor may continue spending money, hoping the situation will turn favorable. Here, the investor falls prey to the sunk cost fallacy, continuing to invest more to justify the already sunk costs.
FAQs About Sunk Cost Fallacy
What is Sunk Cost Fallacy?
Sunk cost fallacy is a concept in economics that refers to the tendency to continue investing in a lost cause due to the amount of resources already committed. This fallacy leads people to make irrational decisions based on past expenses rather than looking at future benefits.
What are some examples of Sunk Cost Fallacy?
Some examples of sunk cost fallacy could include holding onto a non-performing stock due to the original amount invested in it or continuing to repair a broken car instead of buying a new one because of the money already spent on repairs.
How can Sunk Cost Fallacy be avoided?
To avoid the sunk cost fallacy, one needs to make decisions based on future potential rather than past expenditures. It means assessing the current situation objectively, despite the amount of resources already committed.
What is the impact of Sunk Cost Fallacy on business decisions?
The impact of Sunk Cost Fallacy on business decisions can be quite harmful. It can lead to continued investment in failed projects or strategies, resulting in a waste of resources and potentially affecting the viability of the business.
Is Sunk Cost Fallacy a cognitive bias?
Yes, the Sunk Cost Fallacy is considered a form of cognitive bias. It is an error in decision making caused by emotional attachment to past investment, which interferes with our ability to make rational decisions about the future.
Related Entrepreneurship Terms
- Opportunity Cost: This refers to the potential benefits an individual, investor or business misses out on when choosing one alternative over another.
- Fixed Costs: These are business expenses that are not dependent on the level of goods or services produced by the business.
- Variable Costs: These are costs that change in proportion to the good or service that a business produces.
- Financial Decision Making: This is the process of making strategic choices concerning financial resources, taking into consideration the time value of money.
- Behavioral Finance: This term refers to a field of study that proposes psychology-based theories to explain stock market anomalies, such as severe rises or falls in stock price.
Sources for More Information
- Investopedia: A leading global source of financial education, investing, trading, and personal finance news, insights, and reviews.
- The Economist: International weekly newspaper printed in magazine format and published digitally that focuses on current affairs, international business, politics, technology and culture.
- McKinsey & Company: A global management consulting firm that serves a broad mix of private, public and social sector institutions.
- Harvard Business Review: Provides professionals around the world with rigorous insights and best practices to lead themselves and their organizations more effectively and to make a positive impact.
