In Economics, sunk cost is defined as the cost already incurred and cannot be retrieved or recovered.
Rationally, we should make decisions based on the future value of investments, goods, services, and other choices in life. Well, that’s true for the “Econ” (the term used by Richard Thaler to refer to the rational individual always maximizing utility and minimizing costs in traditional Economic theories).
But the human consumer is far from that. Our decisions are tainted with the emotional investments made in costs already incurred, regardless of what the current and future costs and benefits are.
Because we have already put in something that cannot be retrieved anymore, we put more weight on it and stick with the original choice, consequently, foregoing other better options; hence, a fallacy or unsound decision.
This mistake in reasoning is related to the loss aversion principle we discussed in previous articles (Click Loss aversion and Myopic loss aversion to read said articles). We stick to a previous choice made despite its inferiority because abandoning it is actualizing the loss on this investment. Remember, the impact of a loss is twice as much as that of a gain; hence, we would avoid the loss even if it means foregoing the better prospect of switching to a new choice. We get stuck. In the vernacular, “Hindi maka-move on!”
Let’s take a look at some examples.
1. You bought stock A because of an expected growth in the industry and other favorable growth factors. A few months later, the stock lost one third of its value because the factors you assumed in your projection did not materialize. Instead of cutting loss, you put in some more because you feel you can even buy more shares now. You are actually throwing good money after bad.
2. You bought an insurance with investment component without much thought because you just wanted to help your insurance agent-friend. After realizing that you bought a product not suitable and in fact, expensive for your needs, and that you’re better off if you discontinue it and just do your own automated investment in low cost index funds plus a separate low cost term insurance, what do you do? You continue to pay the premium because you already paid two years of premium. Sayang naman.
3. You started watching a movie in order to be entertained. Fifteen minutes into the movie and you feel it’s crappy and your blood pressure seems to be rising instead of being entertained. You continue watching it because you already paid the ticket and there was no way you could refund it.
4. You started reading a book recommended by a friend. You finished two chapters but can’t get yourself interested. You keep at it because you already bought that pricey hard bound book and realize that you’ve already spent a couple of hours reading it.
5. You belong to a family of doctors. On your third year proper, you feel that this is not your calling. You press on because you have already invested a good number of years studying Medicine.
6. You have been working on your chosen career but feel like your yearning is in another field. You go on because you think it’s too late to change careers.
7. You ordered too much food or you’re eating at an eat-all-you-can buffet. You’re now full but you continue to eat until you’re uncomfortably bloated, because you already paid the price.
8. Bad marriage or exclusive relationship that goes on and on despite the obvious that it’s not doing the parties any good but harm. You stay in a bad relationship because you feel that you’ve already invested a good number of years and lots of emotions in it. Oftentimes, the people around you like well-meaning family and friends who have been involved in your romance also contribute to this sunk cost fallacy of keeping the relationship.
9. A wedding doomed from the start. Once a friend confided shortly before the wedding day that he was having seconds thoughts about pushing through with his wedding. After a long discussion narrating their years as a couple, it was obvious that the wedding should not take place. He still decided to push through because of all the years spent together and the wedding preparations already completed and paid for, invitations already sent out. Kahiyaan na lang! Napasubo na! As expected, the marriage did not last.
The Concorde effect
An example of sunk cost fallacy in epic proportions is the Concorde. In 1954, a committee was formed to study the supersonic transport concept. Originally formed among British aircraft and engine manufacturers and the government, France joined in 1962. The first supersonic airliner was already predicted to be a failure early on. By the time it made its first commercial flight on Jan. 21, 1976, the enterprise was already plagued with prohibitive cost overruns but everyone involved kept going.
Reasons or justifications used to go on with the project were to provide employment, to maintain technological expertise, etc., but it was primarily the shared psychological burden outweighing any rational judgment that kept the proponents going. They had already put in considerable time, effort and money (a lot of it was British and French taxpayers’ money) that they could not give up. It was only after decades when they finally threw in the towel with the last Concorde flight on Oct. 24, 2003. They spent a total of 1.3 billion pounds sterling.
With this (mis)adventure, the term Concorde effect or Concorde fallacy was coined to refer to the escalation of commitment resulting in an investment trap which is essentially throwing good money after bad.
Farmville knows it
The developers of the online game Farmville know how to trigger the human addiction to investment due to sunk cost fallacy and loss aversion. Farmville is free. The first time you try you are transported to a world of farmlands where you are enticed to plant. You wait, then you will see the fruits of your effort – harvests, coins, etc. Unlike other games wherein you can just start where you left off, this one isn’t so. If you fail to return after a certain period of time, your investments will die! You won’t do that because you don’t want to waste the time, money and effort that you’ve already put in. But wait! There’s a way to stave off these negative feeling of losing, you can pay Farmville real money or participate in the offers of its advertisers.
Some Farmville players even set alarms to wake up at certain times of the day just so their investments won’t die. I’ve heard some complaining, “Bwisit! Napupuyat ako sa Farmville na ‘yan!” (“Grr… I’m losing sleep over this Farmville!”). You can never get back the time and other resources wasted so you keep going. Somehow, you’re not playing to have fun anymore, but to avoid the negative emotions of losing.
The danger of sunk cost fallacy
The sleepless nights caused by Farmville might not be as dangerous but imagine the harm that sunk cost fallacy can do to us. The individual examples enumerated above such as hopeless relationships, poor investments, getting fat, wasting time, stuck in a career, etc. can ruin our life.
Moreover, sunk cost fallacy by our leaders and decision makers can affect whole nations and the entire world. The Concorde effect took a big toll on British and French taxpayers’ money. Sunk cost fallacy makes our leaders do irrational things such as go to war or continue being at war, keep failed policies and projects alive. Go through history and current events, they are happening all over.
Sunk cost fallacy vs. perseverance/tenacity
So do we give up on our course, career, marriage, stocks, book, movie, project, etc. right away? Don’t we always hear that success stories are made up of perseverance, of not giving up?
Yes. But being aware of this B.E. principle makes us pause and evaluate and ask ourselves the question, “Why am I doing this again?”
The difference between healthy tenacity and sunk cost fallacy lies on how you would answer the question, “If I were to make that decision now, would I still make the same decision?” If your answer is yes, then by all means persevere at it; otherwise, it’s time to move on.
Whether in your investments or other aspects of life, avoid sunk cost fallacy by remembering this:
*The psychology of money series – Feel free to check the author archive for previous installments on this series (The pain of paying, Mental accounting, What is the price we pay for free?, Anchoring effect, Ego depletion, Loss aversion, Myopic loss aversion etc.)
1. My special guest for today on FQ Live! is no other than Wilson Sy, known as the Warren Buffett of the Philippines. He will help us in the discussion of Sunk cost fallacy. PM us your questions now.
2. Want to know your FQ score? Take it today. Click link to take the test. http://tinyurl.com/FQTest
3. I will speak at the “12th Puregold-Tindahan ni Aling Puring Sari-sari Store Convention” with the theme #PanalongPagbabago to be held on May 25, 2017 (Thursday), 1:30 to 2:30 p.m. at the World Trade Center, Manila. My topic is “Pagbabago sa Pananaw sa Pera.” Here are the other speakers.
Rose Fres Fausto is a speaker and author of bestselling books “Raising Pinoy Boys” and “The Retelling of The Richest Man in Babylon” (English and Filipino versions). Click this link to read samples – Books of FQ Mom Rose Fres Fausto. She is a behavioral economist, a certified gallup strengths coach and the grand prize winner of the first Sinag Financial Literacy Digital Journalism Awards. Follow her on Facebook and You Tube as FQ Mom, and Twitter & Instagram as theFQMom.
ATTRIBUTIONS: Images from 1001 Crash, Clipart Net, ClipartFest, Google Play, HF Plumbing & Heating, OnlyGFX.com, PNG Mart, www.prweek.com and YouTube put together to help deliver the message.
Discussions on Concorde from http://leepublish.typepad.com/strategicthinking/2015/03/sunk-cost-fallacy.html, wikipedia
Discussions on Farmville from https://youarenotsosmart.com/2011/03/25/the-sunk-cost-fallacy/
All Credit Goes There : Source link