Of all the bad decisions I’ve made in my life, here are my top three: 1. I once stayed waaaay too long in a bad relationship. 2. I overpaid too much on my first home (16 years ago), and sold it at a huge loss. 3. At various moments in my life, I hold onto things I know I will never need or use in the future. What do all these have in common? They are examples of the sunk cost effect.
What is a Sunk Cost? Why is it a Mental Trap?
In finance and economics, a sunk cost is any cost that has already been paid and cannot be recovered. But our brains aren’t very rational when accounting for these costs. Instead of ignoring them (since you can’t recover the cost anyway), we tend to base future decisions on them. The reasoning is, “I’ve invested so much of my time, effort, or money into this. If I pull out now, it will all have been for nothing.”
The greater the size of our (sunk) cost, the harder it becomes to abandon, and the more we tend to invest further. Even when the return on these additional investments are not worthwhile. What we fail to realise is that if we continue to pour resources into a failing/under-performing endeavour, we’ll end up losing more in the end.
In my bad relationship, it was hard for me to end it because that would mean all that time/emotional investment would evaporate. In some ways, it was easier to soldier on, since there was always a glimmer of hope that things would get better.
When I purchased the expensive home upon graduating from uni, I thought I was “living the dream.” When it turned out that I overpaid for it, I thought, “Well, maybe I could live in it for a very, very long time and it will eventually appreciate past the amount I paid.” But at that time, the market (in the States) was continuing to go down. Still I thought, “I could afford the mortgage, so I might as well pay it.”
It took an outsider to tell me to cut my losses, and abandon any prospects of a near-term market rebound. Painful as it was, I had to sell the home at a 25% loss. One entire year of my salary – gone. But once I realised the loss could never be recovered anyway, I was so relieved to let go of that home.
The time/effort/money had already been spent. These I could never recover. And my mind just needed to come to terms with it.
It’s hard admitting that we’re wrong, or that we made a bad decision. Society teaches us to value grit and perseverance. And we believe that if we stick with our commitments, surely our luck will change. But what if sticking to something ruins us?
Other Examples of the Sunk Cost Effect
1. You ordered dessert and although you feel full, you decide to eat it anyway because you figure, “Well, this will go to waste if I don’t eat it.” (But eating it won’t return your money.)
2. You go out of your way to a specific shop, and don’t find exactly what you need, but you buy something anyway because you don’t want to waste the trip and effort.
3. You go to a shop and see the very long queue, so you end up buying a bit more than usual to justify having to wait in queue. (This one comes up for me every time I go to Daiso.)
4. You sit through a bad movie because you already paid for the ticket.
5. You stick to a certain career or field of study because you’ve already invested so many years of education. Even though it won’t achieve your goals and may be detrimental.
6. A failed business has become your money pit. But instead of cutting your losses, you keep throwing cash at it, hoping it will miraculously bounce back.
7. For organisations, the sunk cost effect may be the reason for keeping under-performing employees; doubling-down on half-finished projects with negative or diminishing returns; or sticking with a current technology or process that’s struggling, instead of adopting a new one.
How You Can Avoid Throwing Good Time/Money at Bad
How can we make smarter decisions, and not simply “stick with” a poor decision we’ve already invested in? It boils down to asking yourself just one question: “Given the information you have at this present moment (and readjusting for your expectation of future cost/benefit), would you still choose to start this activity? (In other words, you have to ignore what you’ve already invested in it.)
So putting a mental block on the past, and examining just this moment in time, would you pick that person to be your boyfriend? Buy that house? Choose that career? Start that business?
Of course, you have to consider the transient nature of many situations. And not quit something prematurely just because of temporary rough patches and rainy days. And for certain things, such as business endeavours and financial investments, you’ll need to account for their cyclical nature. But if the trend continues downward with diminishing benefit and added costs, and a reasonably savvy outsider would not start such an activity, then this should give you pause.
The sunk cost effect is hard to avoid. But thankfully, over time, you will get better at identifying it. And any bad feelings will lessen. The first time I walked out on a bad movie at the cinema, I thought, “I’m already here, would it be a waste of time if I leave?” And I reminded myself that I could not recover the time/money I had already spent, but I could make better use of my future time/money. So I left.
Just recently, I travelled all the way to Sentosa for an event, but then made a quick U-turn because the event was oversubscribed. Yes, I felt some sting from losing all that time (in travelling there), but I knew it would not compare to the additional amount of time I’d have to endure (in the 3-hour queue) had I stayed. And the expected benefit would not justify the additional cost.
The loss of time/money/effort had already occurred. I just needed to come to terms with it, and not let it affect decisions on future time/money/effort. This is something I still struggle with. But I’m getting better at it.
Are there examples of the sunk cost effect in your life?