What is the Sunk Cost Fallacy & How to Avoid Losing Because of It

Budgeting hero-sunken fallacy

Let’s face it: no one likes losing money, especially if you’re living on a budget. In fact, this sentiment is so ingrained into us that we’re actually willing to lose money in order not to lose money. Confused? You should be. This phenomenon is known as the sunk cost fallacy.

That concert you went to even though you dreaded every moment of it because you had the flu—sunk cost fallacy. Or how about those unworn clothes that you keep in your closet simply because you spent money on them—that’s the sunk cost fallacy, too. The thing about sunk cost is that it’s generally a lost cause and it creeps up just about everywhere in life. The cash, time, or resource is gone, so whether or not you make use of the item at-hand makes no difference to your wallet—or your decision to follow through with your commitment or investment. So why go to that show only to have a miserable time?

In this post, we’ll give you a sunk cost definition, dive into the allure behind sunk cost fallacies, and show you how to avoid falling for the sunk cost fallacy. Use the links below to skip ahead, or read all the way through for a comprehensive overview of the sunk cost fallacy.

What is the Sunk Cost Fallacy?

Sunk cost fallacy is the decision to follow through with a business venture or financial investment simply because you’ve spent money on it. The sunk cost fallacy ignores the potential outcome of continuing on with the investment, even if it means you lose more money or end up regretting your decision in the long-run.

To better define the sunk cost fallacy, let’s go over what qualifies as a sunk cost. A sunk cost is an amount that has already been spent and cannot be recovered. A plane ticket that can’t be refunded is a sunk cost. Money spent on advertising a product is also a sunk cost.

Why is the sunk cost fallacy…a fallacy?

Financial experts and psychologists have studied the sunk cost fallacy for years because, frankly, it’s tough to understand why someone would risk losing more money, time, or their happiness just to fulfill a financial commitment that could be going downhill anyway. That’s the fallacy—or mistaken idea, or trickery when put simply.

Click here for some real-life examples to help you better understand sunk costs.

While it might sound outrageous or improbable to fall for the sunk cost trap, it turns out that even those who are well-versed in economics end up caving to the sunk cost phenomenon.

Psychology behind sunk cost fallacy

As we mentioned, the sunk cost fallacy has been a point of interest for psychologists, economists, and other researchers for decades. One study from Ohio University examined how we make decisions when we’ve encountered a sunk cost situation.

In the study, researchers provided survey participants with the following hypothetical scenario. You buy a TV dinner on sale for $3 at your local grocery store, and then you decide to invite your friend over for dinner, too. They initially accept the invitation, so you go ahead and buy them a TV dinner, but the store is out of the $3 options, so you have to buy a second dinner for $5. When you get home, your friend calls to tell you that they have to cancel because they’re ill. Now you’re left with two dinners that you can’t return or freeze, making them a sunk cost. Which one do you eat, the $3 meal, or the $5 one?

Most respondents (66) said that they didn’t have a preference, 21 said they would the more expensive meal, and only 2 said they’d eat the $3 one. Without having any other context than the price of the meal, 21 of the respondents made the decision to eat the pricier meal just because they spent more money on it.

But the sunk cost fallacy doesn’t just pertain to our personal investments; it’s also relevant to the investments of others.

Recent research from Christopher Olivola of the Tepper School of Business at Carnegie Mellon suggests that individuals are driven to follow through with something even if it’s on someone else’s dime—just like we want to protect our own investments. In fact, Olivola found that something as simple as a friend or relative driving a long distance to buy a dessert makes people want to eat the dessert regardless of whether they actually want to or not. In another example, he found that 50% of people would continue to use a gym membership if someone else spent money on it, even if they were injured.

So, why do we fall for the sunk cost fallacy time and time again? MIT.edu provides three hypotheses:

  1. We don’t want to appear wasteful
  2. We want to stick to our plans
  3. We don’t want to accept any loss at all, so we follow through

Olivola said it best when he described sunk cost phenomenon as a “fundamentally human response” that spans across cultures, economic status, and experience.

Examples of the Sunk Cost Fallacy

To help you sniff out and avoid sunk cost traps, let’s go over a few examples of the sunk cost fallacy.

Personal finance

If the examples we discussed above didn’t resonate with you, you can likely relate to this one. You bought a ticket to a concert months ago, spending $30 for general admission. On the day of the show, you have such a stressful day that all you want to do is relax at home with a cup of tea.

You try to get a refund, but the venue doesn’t allow it. You try to sell it online but have no takers. You even try to give it to a friend to lessen your guilt, but no one is available that night. It’s a downright sunk cost.

So, even though you’re not feeling up for it, you decide to go anyway. At best, you have an okay time, and your $30 is gone either way.

The point is, your $30 has already sunk with the ship. If you go and have a bad time, you could end up wasting even more time and money on the show. Alternatively, if you follow your heart and resist the urge to abide by the sunk cost fallacy, you might be in better shape. Either way, economists say that the $30 should not impact your decision much since it’s already long lost.

Business finance

Here’s another example of the sunk cost fallacy. Let’s say you run a startup business. In an effort to improve your sales tracking operations, you decide to buy an organizational software program outright for $20,000. Your staff uses it for a month, but the system just doesn’t jive with your organization. The $20,000 is gone with no way to get it back. Therefore, the amount is a sunk cost and should not have much weight in your decision, according to ideal decision-making.

Personal life

The sunk cost fallacy is such a pervasive concept that it can even impact our personal lives, even when money isn’t involved at all. NPR’s Planet Money examined the relationship between this fiscal phenomenon and love in an interview with economic journalist Megan McArdle.

In the interview, McArdle mentions a date she went on with her then-boyfriend, who admitted to her that he had no intention of saying those three magic words to her anytime soon. She let it slide and later found herself wasting three years on a relationship she knew—from that one moment—wouldn’t last. McArdle said she had fallen for the same economic concept she had written about day in and day out: sunk cost. Despite knowing that the relationship was a lost cause, she continued to invest her time, emotions, and date money into it anyway. Eventually, Megan realized that she didn’t need to pour resources into her failing investments—even in love—and ultimately, she found a relationship worth investing in!

How to Avoid the Sunk Cost Fallacy and Make Better Financial Decisions

Now that you know what the sunk cost fallacy is and have some examples to refer back to, let’s go over a few tips to help you avoid the sunk cost fallacy and make more sound financial decisions.

1. Think big

One of the easiest ways to fall into a sunk cost trap is forgetting your overarching goal or strategy. When dealing with money, many of us are quick to lament over a few dollars lost here and there, but it’s the overall cost that can impact us even more.

Next time you’re calculating your opportunity cost, ask yourself: will it cost me more money to eat this cost now or to keep putting time and money into this investment?

2. Consider the facts

Ask any investor their biggest piece of advice to someone learning about investing in stocks, and they’ll probably mention something about not risking more than you’re willing to lose. If your investment is doing poorly, you might want to cut your losses now, rather than having to deal with a greater sunk cost later.

3. Learn from your mistakes

Whether we’re talking finances, life, or love, we all make mistakes. The important thing is that we learn from them. If you find that you keep buying expensive clothes, but don’t end up wearing them, you might think twice about buying anything new until you know for sure that you’ll use and enjoy the item. An easy way to identify and learn from sunk costs? Take control of your finances with Turbo.

Wrapping Up

Whether you’re evaluating the profitability of your investments or the longevity of your relationship, knowing about the sunk cost fallacy can help you make more logical decisions in all facets of your life. Use these tips to help you evaluate your options, cut your losses where you can, and ultimately lead a more gainful lifestyle!

Sources

Investopedia ⎸ScienceDirect  ⎸ Research Gate  ⎸ Carnegie Mellon University  ⎸ Big Think  ⎸MIT  ⎸ NPR

 

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