Sunk Cost Fallacy
Have you ever been ‘on hold’ with customer service? After a few minutes, you decide to wait a little longer. Five minutes pass and you know you’re close to getting a real person on the line. After ten minutes, you’re frustrated but, at this point, you feel committed. So when do you hang up? How long do you wait? Well, for most of us, the amount of time you’ve been on hold influences your decision to stay on the phone. In reality, however, the time you’ve been on the phone is a ‘sunk cost’ — you can’t get it back. This psychological challenge is known as the sunk cost fallacy and it can be a major barrier to effective investing and financial decision-making.
Yesterday, I received the following email from a client:
We just received an offer for $10,000 on our small plot of land in West Georgia. The offer was much lower than I expected. We don’t use the land but, we’ve invested close to $30,000 into it. In fact, I’m a bit insulted by the offer. What do you think we should do?
This is a classic example of the sunk cost fallacy. The client has compared the offer to their original investment but, the $30,000 is a sunk cost – it’s not coming back. Emotionally, that’s easy to say but tough to accept. I get it. Still, as a rational 3rd party, I responded as follows:
I understand this is a tough decision but I would encourage you to not think about the $30,000 investment as part of the decision criteria. Instead, I would suggest you ask the following question – If you had $10,000 (from selling the land), where would you invest it? If you would reinvest the proceeds back into the land, you shouldn’t take the offer. But, if you would invest the $10,000 somewhere else, then the offer may make sense.
The sunk cost fallacy applies to many different parts of your life.
Ever bought a ticket to an event but didn’t want to go? The cost of the ticket is a sunk cost and your decision to go or not go shouldn’t be based on the money you’ve spent.
Ever had a stock drop and then said, “I’ll wait for it to come back to what I paid and then sell”? The price you paid for the stock is a sunk cost and not relevant to buying or selling.
Ever felt compelled to fix your used car simply because you've invested so much in it? The investment in the car is a sunk cost and shouldn't influence your decision to continue to throw money at it.
Many psychiatrists and behavioral economists attribute the sunk cost fallacy to our general aversion to losses. We all want positive returns from our investments (financial, time, emotion, etc.). And, when we see a potential loss, we want to hold on until it becomes positive. This phenomenon is why most investors sell ‘winners’ too early and hold ‘losers’ too long.
So how do you overcome the sunk cost fallacy? Here are a few suggestions:
Reframe the decision – In the email response above, I reframed the decision from selling the land to investing $10,000 (the offer on the land). By doing so, I can help the client think less about the emotions and investment in the land and, instead, focus on the future.
Focus on the upside – Did the client lose $30,000 or gain $10,000 to invest? Depends on your perspective. By focusing on the long-term potential of investing $10,000, you can train your mind to limit the influence of past decisions and, instead, think about future possibilities. ** **
Stomach the losses – Ultimately, overcoming the sunk cost fallacy requires us to accept a loss. In my client’s situation, it’s $30,000, multiple trips to the property, a vision of building on the land, etc. In other words, the loss is a combination of money, time and emotions and it’s never easy to stomach. Find your process (or rituals) for accepting losses. By doing so, you can push forward with a clear conscious and positive outlook towards the future.
Overall, consciously or subconsciously, we’ve all faced the sunk cost fallacy. The key is to recognize when it’s happening and attempt to overcome it.
Last month, I spent 80 minutes on hold for customer service. At 15 minutes, I thought about the sunk cost fallacy and hanging up the phone. At 45 minutes, I physically tried to put the phone down but couldn’t get it off my ear. At 65 minutes, I was all in…it became a childhood staring contest and I wasn’t going to lose. It happens to all of us.
What are your experiences with the sunk cost fallacy? How do you overcome allowing past decisions to influence your future actions?