Sunk Cost Fallacy

Sunk Cost Fallacy Meaning

Sunk cost fallacy represents the ideology of individuals to continue investing in a decision or project they have already invested in rather than potential future profits. The goal is to help people make better decisions by recognizing when this fallacy influences them.

Sunk cost fallacy can exist in various contexts like business, real life, and social relationships. The cost fallacy relates to individuals experiencing status quo bias and loss aversion bias. Actions based on this fallacy may look irrelevant and irrational, often bringing loss rather than profit. This cognitive bias leads to negative consequences, and poor-decision-making, and reluctance to cut losses.

• The sunk cost fallacy refers to an individual's or organization's tendency to continue investing in a project or decision even when it is no longer profitable because they have sunk high costs.
• The phenomenon is distinct from the gambler fallacy and is linked to loss aversion and the status quo bias theory's mindset.
• Rational thinking, opportunity cost assessment, and tracking sunk costs are important ways to overcome them in professional life and personal relationships.
• People can encounter this fallacy in various areas, such as business, finance, individual decisions, and social relationships.

Sunk Cost Fallacy In Economics Explained

Sunk cost fallacy is the tendency of individuals to repeatedly invest in a decision already invested rather than a potential future profit or cost. According to sunk cost fallacy psychology, people believe that because they have invested so much in something, they must keep investing in it to get returns. Thus, individuals tend to stick with it and be hesitant to abandon it, even if it means staying with it without any growth or desired outcome.

In economics, many analysts and experts define sunk cost fallacy as a situation where firms continue to invest in a project or activity since they have sunk high costs into it, even though it is no longer profitable. It also explains the human behavior of not accepting and sticking with the mistake even when people see no good they can reap. Thus investing in sunk cost fallacy can lead to inefficient allocation of resources and can cause significant economic losses.

This fallacy manifests in daily business, social relationships, and essential life decisions. The sunk cost fallacy in relationships occurs when an individual continues to invest in relationships based on efforts and emotions. They have already invested rather than the possibility of subsequent happiness or success. 

Factors

A variety of behavioral factors can contribute to the sunk cost fallacy psychology, including: 

• People have a stronger adverse reaction to loss aversion than positive gains.
• People view the self-justification of past investments as irrational, regardless of their outcomes.
• When an individual's beliefs and actions are at odds, they tend to feel uncomfortable.
• Feeling emotionally attached to or responsible for a specific decision leads to emotional bias around that decision.

Examples

Let us understand the concept better with the help of an example.

Example #1

Tiffany is a new investor who has always wanted to invest in the banking sector. She comes across two stocks in the banking industry. One investment currently trades at $45; the other is $27. After doing research, she finds that both are equally good banks. So she buys a hundred shares of the second bank's stock, currently trading at $27.

Now, nine months later, the first bank's stock has reached $63, and the share Tiffany bought is currently at $25. She is already at a loss; another six months have passed. Finally, the first bank is trading at the share price of $99, but Tiffany's bought shares have declined to $20. Parallel to this, much bad news and rumors affected the stock price of Tiffany's shares. Still, she was following the irrational behavior of this cost fallacy.

She had time to exit the market, bear a slight loss, and invest her money in the second banking share. But, at last, she did not and held on to the first stock hoping it would one day offer maximum returns.

Example #2

Since sunk costs refer to funds already invested in a decision and cannot be reversed, Peter Drucker, dominant in modern management theory, gives clear advice. First, he suggests asking yourself if investing in a project today based on what you understand now is a good idea, and if the answer is no, get out of the decision as soon as possible.

In a recent research report, Marius Guenzel of the Wharton School of Business claims that companies routinely fail to consider sunk costs, resulting in significant investment losses. He cites two prominent examples of the sunk cost fallacy: the 1970s Aircraft supersonic jet and Facebook's most recent misguided attempt to transform itself into Meta, which cost $30 billion and led to enormous job cuts. Gunezel claims they have made an enormous investment in the Meta venture and are investing even more. All necessary criteria must be met for a situation to qualify as a sunk cost.

How To Overcome?

Overcoming this cost fallacy would be challenging, but it is possible with a few strategies, including:

• Reasoning is the first step toward overcoming the cost fallacy. When a company or individual invests time, money, and effort in a project, they want to maintain it. Therefore, rational thinking allows them to recognize that the benefits of leaving outweigh the disadvantages of remaining.
• It is essential to prioritize future costs and benefits over past investments. The latter allows you to determine whether or not the decision is profitable and in line with your goals and values.
• Individuals typically disregard sunk costs when they compare different options. It is inappropriate, but the process makes sense and provides the most reliable foundation for decision-making.
• To make a rational decision, an individual should seek advice from people who are not emotionally involved. They can offer a fresh perspective and assist you in making an informed decision.
• One can avoid this error by tracking sunk costs and calculating the opportunity cost of exiting the fallacy.
• Do not place blind trust in investments or courses of action.

Sunk Cost Fallacy vs Gambler's Fallacy

• The sunk cost fallacy involves persisting in an endeavor or path due to the previous investment of money, time, and effort. On the other hand, the gambler’s fallacy represents the belief that random events that occurred in the past will repeat themselves to benefit.
• It is based on the price paid in the past. In contrast, it is determined by the results realized in the past.
• This fallacy relates to business, finance, and real life., And the gambler fallacy is typically associated with sports, games, casino bets, and card games.
• Investing in sunk cost fallacy can lead to wasted resources and time, whereas investing in the gambler’s fallacy can lead to irrational gambling behavior.

Frequently Asked Questions (FAQs)

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