A sunk cost refers to any expenditure, financial or otherwise, that has been incurred and cannot be recovered. Once a cost is categorized as sunk, it is no longer relevant to future decision-making processes because it is non-recoverable.
Sunk costs can take various forms, including:
Financial Investments: Money spent on purchases, investments, or projects that have already been made and cannot be refunded.
Time: The time invested in a particular activity or project, which cannot be reclaimed.
Emotional and Psychological Costs: The emotional or psychological toll associated with past decisions or investments.
Resource Allocation: Allocation of resources, such as labor, materials, or equipment, to a project or endeavor that cannot be undone.
To understand sunk costs better, it is essential to recognize their defining characteristics:
Irreversibility: Sunk costs are irreversible; once the money, time, or resources have been spent, they cannot be retrieved or undone.
Independence: Sunk costs are independent of future decisions. They should not influence the evaluation of whether to continue or abandon a project or endeavor.
Non-Recoverable: Sunk costs cannot be recovered or used for alternative purposes. They are considered “sunk” precisely because they are irretrievable.
Past-Oriented: Sunk costs are past-oriented; they pertain to expenditures or investments that have already occurred.
Impact on Decision-Making
Understanding the concept of sunk cost is crucial because it can have a significant impact on decision-making processes. Failing to recognize sunk costs can lead to irrational decision-making and perpetuate poor choices. Here are some common ways in which sunk costs can influence decision-making:
Sunk Cost Fallacy
The sunk cost fallacy is a cognitive bias that occurs when individuals or organizations make decisions based on the desire to “recoup” or justify past investments, even when those investments are sunk and irrelevant to the current decision. This fallacy often leads to suboptimal choices and is driven by emotions and a fear of admitting loss.
For example, consider a business that has invested a substantial amount in a failing project. Rather than objectively assessing the project’s viability based on current information, the decision-makers may be inclined to continue investing in it simply because they have already committed a significant amount of resources. This decision is irrational because it fails to consider whether the project is currently worth pursuing on its own merits.
Escalation of Commitment
Escalation of commitment is a related phenomenon that occurs when individuals or organizations continue to invest more resources (time, money, or effort) into a project or decision, even when evidence suggests that the project is failing or not yielding the expected returns. This escalation is often driven by the desire to “make the investment worthwhile” or avoid admitting failure.
For instance, imagine an individual who has spent a considerable amount of time and money on a degree program that is no longer aligned with their goals or interests. Instead of cutting their losses and pursuing a different path, they may choose to continue the program, hoping that their previous investments will eventually pay off.
Opportunity Cost Neglect
Neglecting opportunity costs is another way in which sunk costs can impact decision-making. Opportunity cost refers to the value of the next best alternative that must be sacrificed when a particular choice is made. When individuals or organizations focus solely on sunk costs, they may overlook the opportunity costs associated with continuing a particular course of action.
For example, a business may have invested a significant amount of time and resources in developing a product that is underperforming in the market. Instead of discontinuing the product, the business may choose to persist because of the sunk costs already incurred. However, by doing so, they may miss out on the opportunity to allocate those resources to a more profitable product or venture.
Emotional Attachment
Emotional attachment to sunk costs can also cloud judgment and influence decision-making. People may develop an emotional connection to investments or projects into which they have poured their time, energy, or resources. This emotional attachment can make it difficult to objectively assess whether continuing the investment is truly worthwhile.
For instance, an individual who has spent years working on a novel may be emotionally attached to the project, even if it becomes clear that the novel is unlikely to be successful or profitable. The emotional attachment may lead them to continue investing time and effort in the project despite the presence of sunk costs.
Making Rational Decisions in the Face of Sunk Costs
To make rational decisions when confronted with sunk costs, individuals and organizations should adopt a forward-looking and objective approach. Here are practical strategies for navigating sunk cost situations effectively:
1. Recognize Sunk Costs
The first step in dealing with sunk costs is to acknowledge and categorize them as non-recoverable. Clearly identify the past investments, whether financial, time, or emotional, that have already been made and cannot be retrieved.
2. Focus on Current and Future Prospects
When evaluating a decision, focus on the current and future prospects of the choice at hand. Consider the potential benefits, costs, and risks associated with the decision without factoring in sunk costs. Ask yourself whether the decision makes sense based on its own merits and current circumstances.
3. Consider Opportunity Costs
Take into account the opportunity costs associated with continuing the current course of action. Ask yourself what you might be giving up in terms of alternative opportunities by persisting with the current decision. Comparing these opportunity costs to the potential benefits can provide valuable insights.
4. Seek Objectivity
Seek objectivity in decision-making by involving others who are not emotionally or financially invested in the sunk costs. External perspectives can offer a more impartial assessment of the situation.
5. Use Decision-Making Frameworks
Utilize decision-making frameworks and tools, such as cost-benefit analysis or decision matrices, to systematically evaluate the pros and cons of a decision. These frameworks can help structure your thinking and avoid the influence of sunk costs.
6. Consider the “If Not Now, When?” Question
Ask yourself whether you would make the same decision today if you were starting from scratch. If the answer is no, it may be a sign that continuing with the decision solely because of sunk costs is not rational.
7. Embrace the Concept of “Cutting Your Losses”
Recognize that cutting your losses and discontinuing an endeavor can be a rational and strategic decision. Avoid falling into the trap of the sunk cost fallacy or escalation of commitment.
8. Learn from Experience
Use past experiences with sunk costs as learning opportunities. Reflect on situations where you may have made decisions influenced by sunk costs and consider how you can approach similar decisions differently in the future.
Sunk Cost in Various Contexts
Sunk cost situations can
arise in numerous aspects of life, from personal finances and business investments to career choices and everyday decision-making. Here are examples of how sunk cost manifests in different contexts:
Business and Investments
A company that has invested substantial resources in the development of a new product may struggle to discontinue it, even if market demand is weak and the product is unlikely to generate profits.
Investors holding onto declining stocks in the hope of recouping their initial investment instead of diversifying their portfolio.
Education and Career
An individual who has spent years pursuing a degree or career path may be reluctant to change direction, even if it no longer aligns with their interests or goals.
Employees remaining in unfulfilling jobs due to the time and effort invested in their current positions.
Personal Finance
Homeowners who have invested a significant down payment into a property that has depreciated in value may be hesitant to sell, hoping to recover their initial investment.
Individuals holding onto expensive gym memberships they rarely use because they have already paid for them.
Consumer Choices
Consumers continuing to use a malfunctioning or outdated smartphone because they paid a high price for it.
People finishing a book they dislike simply because they have already invested time in reading it.
Conclusion
Sunk cost is a fundamental concept in economics and decision-making that highlights the importance of making rational choices based on current and future prospects rather than being influenced by past investments that cannot be recovered. Understanding the characteristics of sunk costs, recognizing their impact on decision-making, and employing practical strategies for navigating sunk cost situations are essential skills for individuals and organizations alike. By adopting a forward-looking and objective approach, individuals can make more rational decisions that align with their goals and values, ultimately leading to more favorable outcomes and better decision-making.
Key Highlights
Definition: A sunk cost refers to any expenditure, financial or otherwise, that has been incurred and cannot be recovered. Once a cost is categorized as sunk, it is no longer relevant to future decision-making processes because it is non-recoverable.
Forms of Sunk Costs: Sunk costs can take various forms, including financial investments, time, emotional and psychological costs, and resource allocation.
Convergent thinking occurs when the solution to a problem can be found by applying established rules and logical reasoning. Whereas divergent thinking is an unstructured problem-solving method where participants are encouraged to develop many innovative ideas or solutions to a given problem. Where convergent thinking might work for larger, mature organizations where divergent thinking is more suited for startups and innovative companies.
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.
The Lindy Effect is a theory about the ageing of non-perishable things, like technology or ideas. Popularized by author Nicholas Nassim Taleb, the Lindy Effect states that non-perishable things like technology age – linearly – in reverse. Therefore, the older an idea or a technology, the same will be its life expectancy.
Antifragility was first coined as a term by author, and options trader Nassim Nicholas Taleb. Antifragility is a characteristic of systems that thrive as a result of stressors, volatility, and randomness. Therefore, Antifragile is the opposite of fragile. Where a fragile thing breaks up to volatility; a robust thing resists volatility. An antifragile thing gets stronger from volatility (provided the level of stressors and randomness doesn’t pass a certain threshold).
Systems thinking is a holistic means of investigating the factors and interactions that could contribute to a potential outcome. It is about thinking non-linearly, and understanding the second-order consequences of actions and input into the system.
Vertical thinking, on the other hand, is a problem-solving approach that favors a selective, analytical, structured, and sequential mindset. The focus of vertical thinking is to arrive at a reasoned, defined solution.
Maslow’s Hammer, otherwise known as the law of the instrument or the Einstellung effect, is a cognitive bias causing an over-reliance on a familiar tool. This can be expressed as the tendency to overuse a known tool (perhaps a hammer) to solve issues that might require a different tool. This problem is persistent in the business world where perhaps known tools or frameworks might be used in the wrong context (like business plans used as planning tools instead of only investors’ pitches).
The Peter Principle was first described by Canadian sociologist Lawrence J. Peter in his 1969 book The Peter Principle. The Peter Principle states that people are continually promoted within an organization until they reach their level of incompetence.
The straw man fallacy describes an argument that misrepresents an opponent’s stance to make rebuttal more convenient. The straw man fallacy is a type of informal logical fallacy, defined as a flaw in the structure of an argument that renders it invalid.
The Streisand Effect is a paradoxical phenomenon where the act of suppressing information to reduce visibility causes it to become more visible. In 2003, Streisand attempted to suppress aerial photographs of her Californian home by suing photographer Kenneth Adelman for an invasion of privacy. Adelman, who Streisand assumed was paparazzi, was instead taking photographs to document and study coastal erosion. In her quest for more privacy, Streisand’s efforts had the opposite effect.
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.
The recognition heuristic is a psychological model of judgment and decision making. It is part of a suite of simple and economical heuristics proposed by psychologists Daniel Goldstein and Gerd Gigerenzer. The recognition heuristic argues that inferences are made about an object based on whether it is recognized or not.
The representativeness heuristic was first described by psychologists Daniel Kahneman and Amos Tversky. The representativeness heuristic judges the probability of an event according to the degree to which that event resembles a broader class. When queried, most will choose the first option because the description of John matches the stereotype we may hold for an archaeologist.
The take-the-best heuristic is a decision-making shortcut that helps an individual choose between several alternatives. The take-the-best (TTB) heuristic decides between two or more alternatives based on a single good attribute, otherwise known as a cue. In the process, less desirable attributes are ignored.
The bundling bias is a cognitive bias in e-commerce where a consumer tends not to use all of the products bought as a group, or bundle. Bundling occurs when individual products or services are sold together as a bundle. Common examples are tickets and experiences. The bundling bias dictates that consumers are less likely to use each item in the bundle. This means that the value of the bundle and indeed the value of each item in the bundle is decreased.
The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.
First-principles thinking – sometimes called reasoning from first principles – is used to reverse-engineer complex problems and encourage creativity. It involves breaking down problems into basic elements and reassembling them from the ground up. Elon Musk is among the strongest proponents of this way of thinking.
The ladder of inference is a conscious or subconscious thinking process where an individual moves from a fact to a decision or action. The ladder of inference was created by academic Chris Argyris to illustrate how people form and then use mental models to make decisions.
Goodhart’s Law is named after British monetary policy theorist and economist Charles Goodhart. Speaking at a conference in Sydney in 1975, Goodhart said that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” Goodhart’s Law states that when a measure becomes a target, it ceases to be a good measure.
The Six Thinking Hats model was created by psychologist Edward de Bono in 1986, who noted that personality type was a key driver of how people approached problem-solving. For example, optimists view situations differently from pessimists. Analytical individuals may generate ideas that a more emotional person would not, and vice versa.
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What in marketing can be associated with social proof.
Moore’s law states that the number of transistors on a microchip doubles approximately every two years. This observation was made by Intel co-founder Gordon Moore in 1965 and it become a guiding principle for the semiconductor industry and has had far-reaching implications for technology as a whole.
Disruptive innovation as a term was first described by Clayton M. Christensen, an American academic and business consultant whom The Economist called “the most influential management thinker of his time.” Disruptive innovation describes the process by which a product or service takes hold at the bottom of a market and eventually displaces established competitors, products, firms, or alliances.
Value migration was first described by author Adrian Slywotzky in his 1996 book Value Migration – How to Think Several Moves Ahead of the Competition. Value migration is the transferal of value-creating forces from outdated business models to something better able to satisfy consumer demands.
The bye-now effect describes the tendency for consumers to think of the word “buy” when they read the word “bye”. In a study that tracked diners at a name-your-own-price restaurant, each diner was asked to read one of two phrases before ordering their meal. The first phrase, “so long”, resulted in diners paying an average of $32 per meal. But when diners recited the phrase “bye bye” before ordering, the average price per meal rose to $45.
Groupthink occurs when well-intentioned individuals make non-optimal or irrational decisions based on a belief that dissent is impossible or on a motivation to conform. Groupthink occurs when members of a group reach a consensus without critical reasoning or evaluation of the alternatives and their consequences.
A stereotype is a fixed and over-generalized belief about a particular group or class of people. These beliefs are based on the false assumption that certain characteristics are common to every individual residing in that group. Many stereotypes have a long and sometimes controversial history and are a direct consequence of various political, social, or economic events. Stereotyping is the process of making assumptions about a person or group of people based on various attributes, including gender, race, religion, or physical traits.
Murphy’s Law states that if anything can go wrong, it will go wrong. Murphy’s Law was named after aerospace engineer Edward A. Murphy. During his time working at Edwards Air Force Base in 1949, Murphy cursed a technician who had improperly wired an electrical component and said, “If there is any way to do it wrong, he’ll find it.”
The law of unintended consequences was first mentioned by British philosopher John Locke when writing to parliament about the unintended effects of interest rate rises. However, it was popularized in 1936 by American sociologist Robert K. Merton who looked at unexpected, unanticipated, and unintended consequences and their impact on society.
Fundamental attribution error is a bias people display when judging the behavior of others. The tendency is to over-emphasize personal characteristics and under-emphasize environmental and situational factors.
Outcome bias describes a tendency to evaluate a decision based on its outcome and not on the process by which the decision was reached. In other words, the quality of a decision is only determined once the outcome is known. Outcome bias occurs when a decision is based on the outcome of previous events without regard for how those events developed.
Hindsight bias is the tendency for people to perceive past events as more predictable than they actually were. The result of a presidential election, for example, seems more obvious when the winner is announced. The same can also be said for the avid sports fan who predicted the correct outcome of a match regardless of whether their team won or lost. Hindsight bias, therefore, is the tendency for an individual to convince themselves that they accurately predicted an event before it happened.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
