What is Sunk Cost Fallacy? And How it Can Affect Your Decisions?
Demystifying Sunk Cost Fallacy: Have you ever been in a situation where you went to watch a movie in the theatre thinking it would be great, however, it turned out to be terrible? What did you do next? Did you walked out of the theater or continued watching it till the end because you were afraid that you have already paid for the ticket? If you choose the latter, you have fallen for the sunk cost fallacy.
In this post, we are going to discuss what exactly is a sunk cost fallacy and how it can affect your investment decisions. But first, let us understand what are sunk costs.
What are sunk costs?
Sunk costs are those irrevocable costs that have already been occurred and cannot be retrieved. Here, the costs can be in terms of your money, time, or any other resource.
For example- Let’s suppose that you bought a brand new machine. However, after using it for three months, you realize that the machine is not actually working as you desired. And obviously, the return period of the machine has surpassed. Here, even if you sell the machine, you will get a depreciated value compared to what you originally bought. This cost is called the sunk cost.
In general, people should not consider sunk costs while making their decisions as these costs are independent of any happenings in the future. However, humans are emotional beings and unlike robots, we do not always make rational decisions.
Examples of Sunk Cost Fallacy
Sunk cost fallacy, also known as Concorde fallacy, is an emotional situation where the individuals take sunk costs into consideration while making the decisions.
We have already discussed the example of watching the entire movie (even if it is terrible) just because you, as a consumer, won’t get back the money for your ticket. This is a classic example of the sunk cost fallacy.
Another example can be when you eat foods that you do not like because you have already bought that food and cannot revoke that sunk cost. Similarly, overeating after ordering foods in restaurants because food has been already ordered is also an example of sunk cost fallacy.
Further, a typical example of the same fallacy is when you keep attending the miserable classes of your college (that you do not enjoy) because you have already invested a lot of time in that course and also have paid the tuition fee. Besides, salaries, loan payments, etc are also considered as sunk costs as you cannot prevent these costs.
A quick point to mention here is that not all past costs are sunk costs. For example, let’s suppose you bought a shoe and you didn’t like it after reaching home. However, as the shoe is still in the return period of 30 days, here, you can return the shoe and get back your purchase price. This is not a case of ‘sunk cost’.
Sunk Cost Dilemma
Sunk cost dilemma is an emotional difficulty to decide whether to continue with the project/deal where you have already spend a lot of money and time (i.e. sunk cost) or to quit because the desired result has not been achieved or because the project has an obscure future.
Here, the dilemma is that the person cannot easily walk away from the project as he has already spent a lot of time and energy. On the other hand, continuously pouring more money, time, and resources into the project also does not seem a good idea because the outcomes are uncertain. This dilemma of deciding whether to proceed further or to quit is called the sunk cost dilemma.
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For example- Let’s say you started a business and invested $200,000 over the last three years. However, you haven’t achieved any wanted results so far. Moreover, you cannot see the business working out in the future. Here, the dilemma is ‘what to do next?’. Should you bear the losses and move on, or should you invest more resources in that uncertain business?
Another common example of a sunk cost dilemma can be a bad marriage. Here, the couples find it difficult to decide whether to save themselves (and their spouse) by splitting up when they are sure that things are not going to work out. Or should they hold on to the marriage just because they have already spend a lot of time together and breaking up will make them look bad?
Sunk cost dilemma in Investing
Even investors are common people and they face the sunk cost dilemma while making their investment decisions.
For example, let’s say that an investor bought a stock at Rs 100. Later, the price of that stock starts declining. In order to minimize the losses, the investor averages out the purchase price by buying more stocks when the price kept falling (also known as Rupee cost averaging). Here, the dilemma happens when the stock keeps underperforming for a stretched period of time. Here, the investors are uncertain whether they should book the loss by selling their stocks, or should they continue averaging out with the hope that they may recover the losses in the future.
Another example of the sunk cost dilemma is people buying/selling aggressively in risky stocks once they have incurred a few major losses in the past to ‘break-even’ those losses. However, the losses have already been incurred, and investing in risky stocks to cover those losses won’t do any good to such investors.
The better approach would be to choose those stocks that can give the best possible returns in the future, not the imaginary aggressive returns that they expect to match up the sunk cost. As an intelligent investor, people should ‘not’ consider the sunk costs while making their decision. However, this is rarely the case.
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It is no denying the fact that nobody likes losing and hence the past losses can influence the future decisions made by the individuals. However, one must not consider sunk costs while making their investment decisions.
As sunk costs cannot be changed (recovered), a rational person should ignore them while making their judgments. Here, if you want to proceed, first you should logically assess whether the project/deal is profitable for the future. If not, then discontinue the project. In other words, try to forecast the future and react accordingly.
Anyways, a few methods of solving the sunk cost dilemma is by opting for incremental wins over the big ones, increasing your options (not just to completely quit or go all-in), and in the terminal case, cutting your losses. When stuck in this dilemma, try to make minimum losses by looking at the mitigating options.
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Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting