Let me pose to you a scenario posed to subjects of a 1985 University of Ohio study:
Imagine that you spent $100 to book a ski trip to Michigan that seemed like it would be a lot of fun. You later spent $50 on a ski trip to Wisconsin that seemed like it would be even more fun. After spending your money on both (and finding out that they cannot be refunded or resold) you realize that the trips are for the same weekend. Which one do you go on?
Most people said that they would go on the $100 trip to Michigan.
(You very well may have picked Wisconsin, but you also were likely on your guard and looking out for a trap. I’m not very sneaky.)
Think about this outcome for a moment. You think that the trip to Wisconsin would be more fun than the trip to Michigan. And yet you take the trip to Michigan, simply because you paid more for it.
No matter which trip you go on, you are out $150. So rationally, we should choose the one that we think will be more fun.
The problem is that we often do not make rational decisions. In this case, it is due to a cognitive bias called the sunk cost fallacy. Colloquially this is often known as throwing good money after bad.
Much like the issue of opportunity cost, the sunk cost fallacy affects our decisions regarding both money and time.
Sunk Cost and Money
One common appearance of the sunk cost fallacy in investing is refusing to let go of a bad investment. If you buy stock in a company and the value of that stock immediately drops, it can be very tempting to hold on to it rather than admit that you lost money. You want to hold on until you at least get back to that break even point. This is the same reason that gamblers will often stay at the table trying to win back their money.
Maybe the fundamentals of the company are still strong and whatever caused the price to drop was just a blip on the radar. But maybe the company is actually on the decline. Be honest with yourself about which situation you see and buy, sell, or hold accordingly.
The question to ask yourself is: “If I didn’t have any money invested in this company, would I invest today?” If not, then you should sell and invest in something more promising.
(You can also avoid this whole fiasco by following Warren Buffett’s advice and buying and holding passive index funds instead of picking individual stocks.)
There is also a specific business application of the sunk cost fallacy called the Concorde fallacy. This is basically the thought that “I’ve spent so much money on this project that it would be a waste if I didn’t finish it.”
The name comes from the 20-year development of the Concorde jet, funded by the British and French governments. The cost was fifteen times higher than the original estimates and as time passed it became clear that the project was commercially unviable. And still, the governments poured more and more money and time into the project so as not to appear to waste the money and time that had already been poured into it. (There is a really interesting article on the Concorde project from the January 1977 issue of The Atlantic if you’re interested: Part 1, Part 2.)
Sunk Cost and Time
One area where I have succumbed to the sunk cost fallacy with respect to my time is in reading bad books. Once I started reading a book I felt obligated to finish it. I had already sunk time into it, so it would be a waste of time not to finish it.
Then I came across Gretchen Rubin, who had faced the same problem. (I believe I first read about this in The Happiness Project, but she also discusses it in this blog post.) She pointed out that if you stop reading a book when you decide that you don’t enjoy it, you then get more time to read books that you do enjoy. This seems pretty obvious now, but is a framing that I had not considered.
The same rationale applies for movies and television shows. If you loved a show for seasons 1-4, but it starts to go off the rails in season 5, you can quit the show and spend that time doing something more enjoyable.
The sunk cost fallacy also shows up in decisions surrounding career paths and relationships. I’ve already spent a decade building up my reputation in this field, so it would feel like a waste to start at the bottom of a different career ladder. But if I am unhappy in my current career path and would be more happy on a different path, then I am letting the fact that I have spent 10 years getting to this unhappy point confine me to further unhappiness.
The same goes for relationships, both friends and significant others. The fact that you have been friends with someone for a long time does not mean that you are obligated to be friends with them forever. Sometimes people change. If someone is a consistently negative influence and is bringing you down, then it may be time to consider walking away.
With both time and money, the question to ask yourself is: Would I still make this decision if I had not already invested this time or money? You want to compare your decision to the decision you would make if you had a completely fresh slate. Once the time or money is gone, it is gone. The only question now is what decision will bring more happiness and value to your life going forward.
How have you dealt with sunk costs in your life? Have you seen other instances of people making decisions based on the sunk cost fallacy? Tell us about it in the comments!