Businesses

What is the Sunk Cost Fallacy? + Learn to Avoid it in 5 Steps

The sunk-cost fallacy is a trap most people fall into. It’s hard to abandon a project once you’ve invested so much of your time and money into the cause.

sunk cost fallacy

 

Unfortunately, the sunk-cost fallacy prevents a very real danger to our lives: by falling for the trap, we risk losing much more than our initial investment in an anxious attempt to recoup the loss.

Here at Toggl, we care a lot about the sunk cost trap–it wastes time that could otherwise have been spent on something productive.

That’s why we built a time management system that can help you run your business and spend your day on the projects that count.

There are a few steps that you should take to wrangle the fear of sunken costs out of your decision-making, but let’s discuss what it is first.

What’s the sunk cost fallacy?

A “sunk cost” is any expense that can’t be refunded or recovered.

For example: once you pay for 10 gallons of gas, the money you spent can’t be recovered–you can’t trade your gas back for money.

Like a ship that’s already sunk, it can’t be revived or taken back in any way.

The sunk cost fallacy goes by a number of aliases, including:

  • Sunk cost effect
  • Sunk cost heuristic
  • Concorde fallacy
  • Argument from waste
  • Investment trap
  • Escalation of commitment
  • Irrational escalation
  • Escalation bias

The American Psychological Association ran a study showing that different cultures experience the sunk cost fallacy in varying degrees.

However, there are two main psychological factors that drive the phenomenon all around the world.

1. Prospect Theory

The prospect theory explains that people make decisions based on the prospects of a decision (essentially, the potential value of losses and gains) rather than on the final outcome. It’s a theory that was developed back in 1979 by Daniel Kahneman and Amos Tversky, who said that because people place more value on potential gains, they’re willing to take more risk.

Another study (from 1986) shows that “people are more risk-averse in gain situations and more riskprone in loss situations.”

This really just means that when people have lost money, they’re willing to take more risks in the hope of recouping the loss. When they’ve already profited, however, they’re more cautious–because they don’t want to lose their gain.

2. Self-Justification Theory

Self-justification theory is another possible cause of sunk-cost fallacy–it suggests that people don’t like to admit that they’re wrong or made a mistake.

In a sunk cost situation, this theory predicts that people will continue a bad investment in order to prove or reaffirm that their original decision was right.

Different reasons, same ultimate effect–falling for the sunk cost trap. At the heart of this fallacy is a fear of “waste”. Our time and money is valuable, and it can be hard to turn away after we’ve invested so much in a project.

How does it affect me and my business?

The sunk-cost fallacy is a little bit like this: imagine you’re a knight on your way to fight the dragon.

You take a wrong turn somewhere and chance upon this twisty, windy path full of thorns, lava, and other generally frightening things.

  • What would you do?
  • If you know that the road up ahead is full of danger, would you continue?

Some people will turn back and try and find a different path, or start a different project entirely (fight an ogre instead, maybe?).

Others, though, might think, “Well, I’ve already traveled this far. I might as well keep going,” despite the fact that they might lose their sword, or worse–their lives (aka investments, business opportunities, etc.).

The sunk cost fallacy will only become more dangerous as you scale.

The stakes get higher, and the investments get larger. Spending $5 on a snack that tastes terrible is easier to stomach than investing $100,000 in a project that’s most likely going to fail.

It’s painful–no one wants to “throw away” 2 years of their lives, or hundreds of thousands of dollars. But the more you focus on past investments, the more cloudy your thinking gets.

Sunk cost bias doesn’t just affect individuals or small businesses.

It affects governments, too.

Governments spend money on new military technology, but they aren’t always successful. Sometimes projects become obsolete before they ever make it to completion. Still, it feels shameful to shutter the project–so they spend more millions to finish the project, instead of using the money to invest in better options.

Logically, the second option makes more sense–why throw money at a project that will never be used?

But the decisions we make aren’t always logical. It’s why we shouldn’t underestimate the threat of sunk cost bias.

How do I know if I’m facing sunk cost bias?

The sunk cost bias isn’t always bad. Under some circumstances, it makes sense to re-invest and recommit to a project.

For example: third-party experts might say that more time and resources could push Project Mario towards failure and away from success.

In this case, it would make sense to consider sunk costs, and to press on at full speed. A management consultant would be able to help you analyze your project, but you can also create a business impact analysis with your own employees.

And in a marriage (relationships are replete with sunk cost fallacies, especially as they grow longer), divorcing after the second fight probably wouldn’t make much sense.

There are differences between setbacks and disasters, so it’s important to analyze which breed of problem you’re facing.

In a relationship: Have I done my best?

In business: Have I already given the project the necessary time and resources for success?

If the answer is “yes” but the project is still failing, then it’s time to walk away.

How can I avoid the sunk cost fallacy?

Robert Leahy, Director of the American Institute for Cognitive Therapy says, “A model of good decision-making is always based on future utility or future payoff.”

Let’s take a look at the different ways you can avoid sunk-cost fallacy in your business.

#1 Build creative tension.

Some businesses strive for total synergy in their organization.

Others, however, prefer to create what’s called “creative tension”.

For example: the United States government has three branches: executive, legislative, and judicial. They work together, but also counter each other, preventing one branch from growing too powerful.

If you have a creative team and a financial team, they will most likely have different goals.

Finances has to make sure the project stays under budget. Creative has to make sure that the project is of high quality.

If Creative had their way, the result might be a gorgeous, way-too-expensive website. But if Finance had their way, the end result might be too lean.

Promoting creative tension and creating an internal system of checks and balances can be a good way to prevent the sunk cost fallacy in your business.

#2 Track your investments and future opportunity costs.

Often, when making business decisions, we only consider the tangible financial costs and benefits of staying the course.

However, it’s important to consider the opportunity costs as well. By sticking to the original course, you give up alternative uses for physical, human, and financial resources.

Keep track of your investments, and make sure you know how much time and money you’ve spent. A good way to do this is to keep a schedule and time the hours you spend on each project.

A great tool to use is Toggl, which will go one step further and alert you when you’ve gone over your time budget. After collecting the data, you can have honest discussions about where those resources are going.

Have an explicit discussion about all the alternative options that you must sacrifice in order to follow through on a sinking project. The results can be eye-opening.

If you’re having trouble thinking of questions to start the conversation, try these:

  • What can we do with the talented people that we’re relying on?
  • What alternative uses exist for the financial and physical assets that we want to use to save this project?

#3 Don’t buy in to blind bravado.

If you stick with a wobbly project because you’re 100% convinced that it’s going to succeed, you’re…gonna have a bad time.

As a leader, plan for the conversation that must eventually happen if you must cut your losses. Don’t think of it as admitting defeat–think of it as redirecting those valuable resources (the real defeat would be losing any more of them) to more productive endeavors.

In 1996, David Breashears, a famous Emmy Award-winning filmmaker and accomplished climber, had to make the decision to turn around while hiking Mt. Everest because they realized a blizzard was forming.

As they descended the mountain and returned to base camp, they passed some fellow climbers continue the journey up. That blizzard eventually turned into the 1996 Mount Everest disaster, where 8 people got caught in the storm and died.

We’re often taught to applaud grit and perseverance, but there has to be a limit.

Pure bravery in the sheer of overwhelming obstacles will only lead to disaster–had Breashears insisted on continuing their climb, his team could have lost their lives as well.

As leaders, you’re responsible for your team and tribes’ safety. If you let pride and emotion cloud your judgment, you could do a lot of harm to the overall organization.

Speaking of emotion…

#4 Let go of your personal attachments to the project.

The second noble truth of Buddhism is that pain is caused by emotional attachment to things.

Whether you’re a Buddhist or not, this point links back to the self-justification theory–in an effort to escape from change and shame, we cling to our original decisions even though we know they have a great chance of failing.

Instead of walking out into the sunlight, we end up lost in the woods.

Shuttering projects that have taken up so much money and time is never easy, especially when you have to break the news to the rest of your teammates.

The more emotional attachment we have to a project, the harder it is to admit that it won’t succeed.

The sunk cost fallacy likes to attack when we’re down. If our performance rating or our job depends on the success of a project, or we want to succeed to prove a point, we’re more likely to barrel onwards.

No one wants to be a leader that creates failed projects–to protect our reputation and standing, we might disregard clear signs of danger.

The same happens in relationships: after all, what are we supposed to do when we’ve been with the same person for decades?

It seems like a waste to just “throw away” three or four decades, right?

And you want to make it work–you don’t want the stigma of failure.

Let go of it.

Let go of the fear of failure. Let go of the fear of waste. By understanding that 1) things in this world change and grow, and that 2) not all projects will succeed, we can ease our grip on the reins and slow down.

#5 Look ahead to the future.

The sunk cost fallacy is all about looking over your shoulder (so often that you start getting a crick in the neck). Time is spent looking back at the path you’ve already walked, and the obstacles you’ve already faced.

Past investment.

Past risk.

Past choices.

It’s not very compatible with business decision-making, which focuses on getting future results.

Think about what you want to achieve in the future, and reflect–is it really possible?

Will you be able to achieve the goals that you set wayyy back before you started the whole project?

Be honest and realistic.

If the future looks lighter and brighter without the project in your plans, then cut your losses and let it go.

When you’re bleeding, you’d use a bandaid, right?

Investing more money on a project you know will fail is like taking a blunt object and making the wound bigger.

Don’t. Do. That.

Us humans are imperfect judges of self-interest, and we have a strong natural aversion to loss (according to Kahneman and Tversky, anyways).

Keep that in mind when you’re planning your portfolio, reflecting on a current relationship, or thinking about making a big investment. We feel the pain of loss more keenly than the pleasure of success–and that pain can make us do some crazy things.

What do you really want now?

What are the patterns in your own decision-making, and how can you refine them?

By refreshing your mind and letting go of your fear and attachment to (f)ailing projects, you can make room for better, brighter things.

And who knows?

Maybe you’ll unlock a better world of opportunities.

By On April 5, 2018