Sunk costs
Behavioral New World
April 1, 2022
Sunk costs—don’t get weighed down[1]
A sunk cost is a payment or expense that you’ve made that can’t be undone. You paid the money, it’s gone, that’s it. For example, if you have bought a ticket to a football game – the kind you are not allowed to resell – the money you spent on that ticket is sunk. The money is gone the minute you spent it, as if it has sunk to the bottom of the ocean and will be there forever. (And don’t expect Jacques Cousteau or anyone else to go get it for you.)
The qualification “not allowed to resell it” is important. If you could sell it for what you paid for it, none of the ticket price would be sunk. If you could resell it for half of what you paid for it, half of the expense is a sunk cost. When I use the phrase “sunk cost,” I’m referring to that part of the expense that is genuinely irretrievable. It may be the full expense, or just a fraction of it.
Why are sunk costs important to clear thinking? Answer: from a purely logical (but not emotional) point of view, a sunk cost should in no way influence any decisions we make now or in the future. The irretrievability of a sunk cost means that it is irrelevant to decision making from the point of expenditure onward. Returning to the football ticket example, if its cost is sunk, your ownership of the ticket should not influence whether you go to the game. Going to the game will not allow you to reclaim the money: it is gone, whether you go or not.
This conclusion, which sounds reasonable to most economists, sounds rather unreasonable to many noneconomists. “I’ve spent the money, so I feel that I should go” is a common reaction. The primary reason that people feel that way is they are trying to minimize any regret they might have about the decision. However, it is important to recognize that going to the game (presumably) seemed like a good decision at the time the ticket was purchased. Somehow later, and for whatever reason, it may not seem like that at all. Hindsight is 20/20, but you shouldn’t use hindsight to judge your initial decision. (My March 1, 2021 newsletter describes hindsight bias.)
So how should you think about whether to go to the game? On game day suppose it is cold and rainy outside, and you’re coming down with a nasty cold. Is it in your best interest to attend? Almost certainly not. What if it is cold and rainy, but you are healthy? Well, that’s probably a harder decision. It depends on your desire to see the game and your tolerance of cold and rainy weather. Your call. What if it is a beautiful day, you’re feeling great, and it promises to be an exciting game? Then you are likely to go and enjoy the experience. In this context, the decision to go certainly makes sense.
But notice that your decision does not depend on the money you spent on the ticket (I’m assuming its full cost is sunk: there is no refund available). It is irrelevant to your decision, as it should be. The behavioral part of this story is the regret that you might feel about “wasting” the money. But it was wasted at the time you bought the ticket (although you only know that after the fact). The regret, like many of our behavioral instincts, is understandable but not purely rational, and can lead us astray.
So what can we do? As always, the first step in countering any bias is awareness. You can ask yourself: Is the money I’m thinking about in fact a sunk cost? Has my behavior changed because of the sunk cost? Once you have contemplated these questions, take a deep breath, calm down, and commit to make a more rational decision. Engage your analytical mind, sometimes referred to as “System 2.”
And here’s a little trick to reduce the dysfunctional influence of sunk costs on our decision making: Recent research shows that “…a human name for an investment increases sunk cost consideration when people make a decision to terminate the investment.”[2] Wow, that’s interesting! As applied to our football ticket example, it suggests you should think about your football ticket as “the” ticket, not “my” ticket or, even worse, “John’s” ticket.
By understanding and avoiding the sunk cost fallacy, you avoid sinking to the dark depths of murky thinking. Your intellectual buoyancy will make for smoother sailing through life.
P.S. Last month’s newsletter encouraged you to submit a bias that you think might exist (real) or one that you make up for laughs. Here’s one from S.C.:
The Harvard Mis-Comparison Effect. “We’re the Harvard of [our region, e.g., the Midwest]” Prominent among high-level administrators at large public universities.
I will share others in future emails. I welcome more at jstuarthowe@hushmail.com.
And check out my new website: jshowe.com
[1] This material is drawn from Chapter 8 of my book, The Foolish Corner (available on Amazon).
[2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3973830