Sunk-Cost Fallacy

Well… maybe not. We often feel we need to follow things to the end because we’ve already invested our time, attention or money. As if, regardless of what the outcome actually is, the energy we put into something must then amount to some sense of accomplishment or material benefit.

In business terms, this investment is often referred to as a ‘sunk cost’. A sunk cost refers to an expense that cannot be recouped, regardless of future events. As a general rule, businesses should avoid being influenced by their sunk costs because there is no way of recovering the investment. When a business or investor does pour more money into trying to recover past losses, they risk succumbing to the ‘sunk cost fallacy’. The saying "Don't throw good money after bad" serves as a warning against this kind of decision making.

Sunk cost examples

Putting sunk costs into practice is a great way to help you understand what we’re actually talking about. Here are some examples:

Past investments in projects: Money already spent on a project, such as research and development costs, that cannot be recovered even if the project is abandoned.

Non-refundable deposits: Payments made for goods, services, or reservations that cannot be refunded, such as deposits on rental properties or event bookings.

Advertising expenses: Money spent on marketing campaigns that have already run their course and cannot be reclaimed, regardless of the campaign's success or failure.

Equipment or asset purchases: The cost of equipment or other assets that have been purchased and depreciated, especially if the asset cannot be sold or has little resale value.

Training and onboarding costs: Expenses related to training employees, especially if those employees leave the company or the training is no longer relevant.

Contractual penalties: Payments made due to breach of contract or penalties for cancelling agreements, which cannot be recovered once paid.

Software and licensing fees: Costs for software licences or subscriptions that have already been paid for and cannot be refunded, even if the software is no longer used.

Research and development (R&D) costs: Money spent on developing new products or technologies that are ultimately abandoned or fail to reach the market.

Okay, so what is the sunk-cost fallacy?

The way the sunk cost fallacy works is when a company or individual feels compelled to continue with a plan simply because resources have already been invested. This fallacy stems from the belief that sticking to the current course is justified by prior commitments, leading to poor long-term strategic decisions based on short-term costs.

For example, consider a college student choosing their major. If a student declares an accounting major but later realises after taking a few classes that it's not the right fit, they might think that they need to stay in the major because they've already invested time and effort. This is where the sunk cost fallacy kicks in, influencing the student to invest more time and money into a career they ultimately don’t want.

In business, the sunk cost fallacy occurs when management insists on following through with original plans, even when those plans are clearly not working out and are greater than necessary present and future costs. This fallacy is driven by emotional investment, which can lead to irrational human decision processes.

Sunk-cost fallacy in action

‘The Concorde fallacy’

As perhaps the most famous example of the sunk-cost fallacy, the British and French governments continued funding and operation of the Concorde aircraft despite mounting evidence that it would not be commercially viable. The decision to persist was driven by the substantial financial and political resources already committed, rather than a rational assessment of future prospects. The Concorde project ultimately became a financial loss, with continued investment epitomising the sunk cost fallacy where the size of the initial investment influenced ongoing fiscal decisions about the project.

The Vietnam War

Another well-known example of the sunk cost fallacy is the U.S. involvement in the Vietnam War. Despite the mounting costs—both financial and human—and growing evidence that the war was not winnable, the U.S. government and allied powers continued to escalate their military commitment. This prolonged involvement in Vietnam is often cited as a classic example of the sunk cost fallacy, where decision-makers allowed past expenditures to dictate future military and economic behaviour, resulting in further losses.

How to avoid the sunk cost fallacy

Overcoming the sunk cost effect requires mindfulness, dedication, and thoughtful planning. Here are some key strategies to help you avoid this mental trap:

1. Frame the problem clearly: Begin decision-making by identifying a specific problem that needs to be solved. This problem should be the central focus of all discussions and actions, helping to distinguish what is truly important from irrelevant distractions.
2. Maintain independence: Emotional attachment to and a sense of personal responsibility for business decisions can cloud judgement. It’s essential to stay objective and remember that unsuccessful projects don’t necessarily reflect poorly on the decision-maker. What matters most is making the right decision moving forward, and avoiding psychological factors that encourage you and your business to start throwing good money down the drain.
3. Trust the data: When evaluating options, it’s important to exclude sunk costs from your analysis. Although this might feel counterintuitive, doing so ensures that decisions are based on the most reliable and relevant information, leading to better outcomes.
4. Adjust your risk preferences: Some investors seek out high-risk opportunities, believing they offer the greatest returns, while others prefer to avoid risk entirely. By becoming more comfortable with risk and understanding that it’s okay for some of your invested money to be irretrievable, investors can make more rational decisions without being paralyzed by past losses.

Recognizing sunk costs and the sunk-cost fallacy is essential for making rational decisions in both business and everyday life. Unlike the well-meaning people behind the Concorde, being aware of how past investments can cloud judgement, we can avoid the mistake of committing additional resources to unviable ventures. The focus should be on what makes sense for the future rather than attempting to validate past expenditures. Clear problem framing, objective analysis, reliance on data, and a balanced approach to risk are key strategies in overcoming this bias. It's about making choices that serve current and future goals rather than being held back by past commitments.