A few years ago, I wasted more time in a shitty relationship than I care to admit.
For whatever reason, things began to turn sour. The writing was on the wall. Unmissable, unmistakable, irrecoverable: it was over. But month after month, like suckers for punishment, we made each other – and ourselves – increasingly miserable.
While our relationship repelled us from one another, one force united us: the time we’d already invested together. We’d spent so much time together already. Giving up now would feel like a waste. All those memories. All that time. Down the toilet. Surely, with a little effort on both sides, we could return to how we once were? Surely that was worth throwing extra time behind?
It wasn’t, of course. Because the writing was already written. We’d reached and recognised this point over many months prior. We’d tried to change for one another – not realising that our desire to change one another was a telling marker of our incompatibility.
And so, after many unnecessary and unhappy months clinging onto a lost cause, we eventually let go, starting the grieving process that should have started months earlier.
What Is the Sunk Cost Fallacy?
What got in the way of a quicker decision for the benefit of both of us is a common bias. The sunk cost fallacy is where we allow a cost that is already gone and has no future influence on returns – in this case, time – to drive a continued behaviour or endeavour, even when it’s not in our own interests.
Examples of the Sunk Cost Fallacy
Of course, the sunk cost fallacy isn’t limited to relationships. To illustrate this point, ask yourself the below questions and see if you can honestly say you’ve not fallen into any of these traps a few times.
Have you ever endured an awful film because you paid for the cinema ticket, or because you already got an hour in?
Ever battled your way through a book, to no obvious benefit other than to finish it?
Have you ever purchased something non-refundable in advance, not felt like doing it at the time, and then gone only because you’d paid for it?
Have you ever held onto an investment doomed to fail, simply because you’d already invested?
Ever held onto something you don’t use, just because it was expensive?
If you answered yes to any of these questions, you’re not alone. And that’s because there is a predictable psychology that underpins them.
The Psychology of Waste
We intuitively don’t like waste or loss, and this intuition often comes at the expense of rationality. Relationships go on for longer than they should, crappy films get watched until the end, and losses widen on doomed investments because we quite simply hate the idea of waste.
As human beings, we don’t frame decisions like homo economicus, rationally appraising the alternatives to bring us maximum utility. Instead, waste and loss play heavily on our choices.
This is perhaps best illustrated by what psychologists call loss aversion, the tendency for people to prefer avoiding losses to acquiring equivalent gains. And this isn’t a preference of fine margins. A seminal study by Amos Tversky and Daniel Kahneman suggested that losses are psychologically twice as powerful as gains.
It becomes easy to see how sunk costs distort our decision making and leave us holding onto stuff. The idea of waste and loss associated with sunk costs often outweighs the possibility that continuing with a behaviour may bring more loss. What’s more, our sunk costs can blind us from the better alternatives. This psychology can prove financially, emotionally and temporally expensive.
How to Overcome the Sunk Cost Fallacy
The question, then, is how can we manage it? And like all good problem solving, we must begin at its root.
#1: Don’t forget waste; anticipate it
“But, but, but… If I stop worrying about waste, how is that going to help me financially?!”
The key to combatting against the sunk cost fallacy is not to forget waste; it’s to anticipate it and change course. That means that when we’re thinking about a purchase, we need to be honest with ourselves about whether we’re likely to have a change of heart.
Not keeping or not attending something may feel like a waste, but keeping or attending something that brings us no value at all is a far greater waste.
The problem is therefore best treated at source. If we can anticipate and avoid sunk costs that don’t add value, we eliminate the risk. Simple as that.
But, of course, this isn’t always possible, nor are outcomes always in our hands. In these instances, two other important strategies might be deployed.
#2: Evaluate the opportunity costs
When we are in the clutches of the sunk cost fallacy, failure to appraise better alternatives creates an opportunity cost to continuing a behaviour.
If we decide to continue investing our time in a crappy film, we give up the alternative uses for that time. If we decide to hold onto a failing investment for longer, we give up the alternative, potentially profitable uses for that money, as well as extending our financial losses.
Opportunity costs are what we sacrifice when we allow sunk costs to perpetuate our current pattern of decision making. It follows that fully evaluating the alternatives before we make these sacrifices can help guide more informed choices.
#3: Mere awareness
Ignorance breeds confidence, and knowledge regulates it. Simply educating ourselves on cognitive biases can help us control our natural propensity to fall into their traps.
Don’t believe me? Take a look at some of the research.
One study put participants through a one-shot training on cognitive biases and found that they subsequently made more rational decisions than a control group. Other researchers are increasingly looking at the impact of behavioural finance education on investing. Numerous studies suggest that education on cognitive biases like the sunk cost fallacy can improve investing decisions.
A basic understanding of the sunk cost fallacy can be the red flag that helps provoke questions like “what is the opportunity cost?” and “can waste be anticipated and avoided?”
Summary
- The sunk cost fallacy is where we allow an irrecoverable cost with no future influence on returns to drive a continued behaviour or endeavour, even when it’s not in our own interests.
- We encounter sunk costs every day in investments of our time, money and emotional energy.
- We can protect our decisions from the sunk cost fallacy by anticipating waste and changing course, evaluating the opportunity costs of alternatives, and educating ourselves on the sunk cost fallacy and other cognitive biases.
