Investor's Psychology

What is Sunk Cost Fallacy: Are you as Smart as you Think!

Created on 18 Nov 2020

Wraps up in 5 Min

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Updated on 27 Aug 2022

Have you ever bought the tickets to a concert. And on the day of the event, you catch a cold. Even though you are sick, you decide to go to the concert because otherwise “you would have wasted your money”.

Boom! You just fell for the sunk cost fallacy. In this article, we will talk about what precisely is a sunk cost fallacy and how it can influence your decision making.

What are Sunk Costs?

Sunk costs are those permanent costs that have been incurred and cannot be recovered. Here, the expenses can be your money, time, or other asset. For instance, the tuition fees of your college is a sunk cost, as it is an expense that cannot be recovered. This is irrespective of whether you get a job after college or not.

The sunk cost fallacy occurs because we are not purely rational decision-makers and are often influenced by our emotions. When we have previously made an investment into a choice, we are likely to feel guilty or regretful if we do not follow through on that decision. The sunk cost fallacy is associated with commitment bias, where we continue to support our past decisions despite new evidence suggesting that it isn’t the best course of action.

Sunk Cost Examples

Have you ever been in a circumstance where you headed out to watch a movie in the auditorium, thinking it would be incredible? After 30 minutes into watching a movie, you realized that it was awful but continued to watch it anyway? This is because of the sunk-cost fallacy. We continue wasting our time on a boring movie since we have already paid for the tickets and invested 30 minutes of our time into it already.

Another example can be when you eat food you don't like, simply because you have just purchased that food and can't deny that sunk cost. Likewise, indulging in overeating after ordering food in restaurants just because a food order has already been placed, is also a case of sunk cost fallacy.

Further, a run of the mill case of a similar fallacy is the point at which you continue going to the boring classes of your school (that you loathe) just because you have invested in that course and furthermore have paid the educational cost. Plus, compensations, advance instalments, and so forth are likewise considered as sunk costs as you can't prevent these expenses.

A fast highlight to mark here is that not all previous expenses are sunk costs. Consider this, you purchased a shoe from an online store and you didn't like it after trying it on. Be that as it may, as the shoe is still within the return period of 30 days, here, you can return the shoe and still get back your money. This isn't an instance of a 'sunk cost'.

Sunk Cost Dilemma

The Sunk Cost dilemma is used to describe a situation of intense confusion for deciding whether to proceed with the venture/deal in which you have invested money and time (i.e. sunk cost) or to stop because the ideal outcome has not been accomplished or because the project has a dark future.

Here, the dilemma is that the individual can only, with significant effort, leave the project as he has just invested a ton of money, time, and energy. Then again, ceaselessly pouring more money, time, and resources into the task additionally, wouldn't really be a smart move because the results are mostly unpredictable. This dilemma of deciding whether to continue further or to stop is known as the sunk cost dilemma.

One example of a sunk cost dilemma can be a bad marriage. Here, the couples find it hard to decide whether to spare themselves (and their life partner) by separating when they are certain that things won't work out. Or then again, would it be a good idea for them to hold on to the marriage as they have been and separating will make them look terrible?

Let's take another example, say you bought new paint for your house. You thought it would look good, but after painting two rooms with it you've decided it's not what you wanted in your house. But you've already spent money on paint and started painting the house. Now you've wound up in the sunk cost dilemma. Do you buy a new color of paint that's more to your liking, or do you stick with it and paint the rest of your house this color?

Sunk Cost Dilemma in Investments

The Sunk Cost Dilemma is a formal monetary term that portrays the trouble of deciding whether to continue with an investment or desert it when the time and cash have been spent and the ideal outcomes have not yet been accomplished. The Sunk Cost Dilemma is additionally called the Concorde Fallacy.

For instance, suppose that a financial specialist purchased a stock at Rs 1000. Afterwards, the cost of that stock starts declining. To limit the losses, the investor averages out the purchase price by acquiring more stocks when the cost continues to fall.

Here, the dilemma happens when the stock continues to fail to meet expectations for an extended period. In such a case, the investors question whether they should book the loss by selling their stocks, or should they keep averaging out with the expectation that they may recover the losses later on.

Another case of the sunk cost dilemma is individuals forcefully purchasing/selling in risky stocks whenever they have faced some significant losses in the past, to 'equal the initial investment' on those losses. Be that as it may, the losses have already occurred, and investing in dangerous stocks to cover those losses won't benefit much to such financial specialists.

The better course of action will be to pick those stocks that can give the most ideal returns later on, and not the nonexistent forceful returns that they hope to coordinate with the sunk expense. As savvy investor, individuals should 'not' think about sunk expenses while settling on their choice. Nonetheless, this is a once in a while case.

The Bottom Line

There is no denying that no one wants to face any losses, and thus the previous losses faced by people can impact their future choices. In any case, one must not think about sunk costs while making a decision.

As sunk costs can't be changed (recovered), a balanced individual should disregard them while making their decisions. Here, if you need to continue, first you must intelligently evaluate whether the investment/deal is beneficial for what's to come. If not, at that point, it is better to suspend the investment. It is advisable to attempt to estimate the future and respond likewise.

At any rate, a couple of techniques for overcoming the sunk cost dilemma are by choosing gradual successes over the huge ones, expanding your choices (not simply to stop or bet everything), and in the terminal case, cutting down your losses.

When stuck in this dilemma, it is advisable to attempt to make the least misfortunes by looking at the less risky alternatives, thus choosing a safer investment.

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Ishita Jha

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Ishita Jha is an MBA Finance student of BIMTECH, now a blogger; trying to survive the pandemic recruitments. She can be found researching, exercising, and binging to balance life. She finds her happy place in writing.

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