You’re finally taking that much-deserved vacation in the Caribbean. You found the perfect resort online—at a great price—and impressed your friends with your ability to find such a cheap deal at such a beautiful place. You put down a deposit. Then you arrive and discover that those five star reviews were three years old. Today, the hotel is a rat trap. Your deposit is non-refundable.
What will you do next? You have two options.
- Option 1: Cut your losses, walk away, and find the resort of your dreams—somewhere else on the island.
- Option 2: Stick with the hotel you booked, because—after all—you’ve already made that deposit, and you don’t want to lose it. Besides, if you walk away now, your friends will know you made a rookie mistake—you were fooled by a pretty online photograph.
Surprisingly, according to some research, you are more likely to choose option 2. The outcome, almost certainly, would be an unpleasant vacation—exactly the opposite of you wanted in the first place. In other words, most people tend to choose the option in which they’ve already invested time, money, and/or personal pride—even when that option is clearly not likely to provide the best outcome. This type of decision is called a “sunk cost fallacy,” based on a “sunk cost bias.”
What Is a Sunk Cost?
A “sunk cost” is an investment that has already been made. It can be an investment of money, time, energy, love, or even personal pride. Sunk cost fallacy is the belief that anything you’ve already invested in deserves greater investment—even if it was a poor investment in the first place, and even if the investment is unlikely to lead to the desired outcome.
Sunk cost bias is a common problem for individuals—but it can also become a serious issue for businesses and government agencies. For example:
- You’re an entrepreneur or small business owner who’s already invested time, money, and personal pride in a product that performs poorly and is unlikely to ever break even much less make a profit. So you plow all your remaining assets into the product, rather than admitting that it was a poor choice in the first place, pulling the plug, and moving on.
- You’re the military arm of a national government, and you’ve already sunk millions—or billions—into a military plane that’s obsolete before it ever reaches a runway. So you recommit to more millions to finish the project, rather than looking at better options for military air power.
- You’re a corporate executive who championed an advertising campaign that failed miserably. So you tell your staff to spend more money to shore up that same campaign concept.
What’s So Bad About Sunk Cost Bias?
Most people are biased toward investments they’ve already made. They’ve put so much into a project, product, relationship, or plan of action that they don’t want to “waste” effort.
Under some circumstances, this makes sense—especially when the investment is important, and clear-eyed observation indicates that more time or resources could make the difference between failure and success. No one, for example, would recommend giving up on a marriage at the first sign of trouble—or dumping a major new business project because of a small setback.
But what happens if you’ve already given that relationship, product, or project all the time and resources it should need for success—and it’s still failing?
Logic, along with the laws of probability, tells you to walk away.
Yet many people and businesses stick with their poor choices because they believe so strongly that they should protect their investment at any cost. This, as Robert Leahy, a psychiatrist and Director of the American Institute for Cognitive Therapy in New York says, is a poor idea. As Leahy explains in an article in Forbes: “A model of good decision-making is always based on future utility or future payoff.”
Why It Makes Sense to Stop Throwing Good Money After Bad (And Why We Do It Anyway)
Imagine flipping a coin and betting that it will come up heads. It comes up tails. So you double your bet—because it’s more likely to come up heads next time, right? What if it comes up tails five times in row? In that case, it’s much more likely to come up heads the sixth time, right?
Actually, according to the laws of probability, the coin is no more likely to come up heads just because it came up tails last time. There is always a 50% chance that it will come up heads. But most of us find this mathematical reality very difficult to accept. It just feels wrong. The result of betting on a sunk cost fallacy in this case? If you kept doubling your bet every time you lost the coin toss, you’d be subjecting yourself to a 50% failure rate—over and over again.
Looking at it that way, it seems foolish to keep throwing good money after bad. Why keep on making the same bet with the same high odds of losing? But psychologically we are programmed to do just that. As a result, we:
- Increase our investment in failing products, programs, and people;
- Refuse to cut our losses when we can see that the outcome will be even greater loss;
- See ourselves as “stuck with” the consequences of poor decisions, and choose not to make smarter decisions for the future.
This can be devastating for people in abusive relationships, soul-numbing jobs, money pit homes, or dead-end lifestyles. It can also be devastating, of course, for businesses.
Why do people fall into the trap of the sunk cost fallacy? There are many reasons.
- We don’t understand that past investments need not affect future investments.
- We are “programmed” to believe that grit and tenacity are more important than common sense.
- We believe that if we stick with our commitments our luck will change.
- We are often too proud to admit that we were wrong.
- We have a built-in bias toward those decisions that we personally make.
- We are, as a species, extremely uncomfortable with the idea of letting go of something we already have in our hands—even when there is a better alternative available.
- We tend to forget why we made initial investments—and mistakenly tell ourselves that the investment itself is the point.
How Does the Sunk Cost Fallacy Affect Businesses?
Perhaps the most famous example of the impact of sunk cost fallacy on business is aptly nicknamed “The Concorde Fallacy.” The Concorde was a supersonic (faster-than-sound) airplane designed for elite travelers, funded by the British and French governments.
Even before the plane was completed, it was clear that it would not be a financial success. Despite this knowledge, the two governments continued to shell out money to fund the project’s completion. Not surprisingly, the project launched, fizzled, and quickly died—along with any hope of recouping the huge amount of money invested.
Why would usually-rational people decide to continue investing in a project that has essentially failed before it even started? The decision to support an investment at any cost is largely psychological rather than rational. Here’s why:
- We tend to think positively about people and projects we ourselves have initiated—even when they are not working out.
- We tend to link our sense of self-worth to the initiatives we launch or support, even when they don’t succeed.
- We are afraid to “lose face” as individuals or organizations by admitting to mistakes.
- We value tenacity and grit in ourselves and our employees, even when its outcome is continued financial loss.
If we are hard-wired (or at least behaviorally taught) to throw good money after bad, how can we avoid the sunk loss fallacy in business? There are some simple strategies that can help. Specifically:
- Recognize a sunk cost when you see one. Every investment you’ve already made is money spent. No matter what choice you make today, you won’t be able to recover the sunk cost. So... what’s the best move you can make for the future?
- Remember that “I’ve already put so much into this” is not a valid reason for sticking with an expensive enterprise that isn’t working out.
- Separate your personal pride from your business decisions. Would you look stupid walking away from that pet project you’ve put so much into? Possibly. But you’d look even worse in bankruptcy proceedings!
- Include multiple decision makers in the decision-making process, so that the person who made the initial decision to invest is not the only person involved with thinking about future investment.
- Remind yourself of the reason you invested in the first place. Are you achieving the goal you set for your company—or are you just emotionally attached to your investment?
- Consider the options available to you if you choose not to re-invest. Could you make better use of your time and money?
Sunk-Cost Bias: Lessons for Entrepreneurs
Entrepreneurs, perhaps more than many other business people, are prone to fall victim to sunk cost bias. Why? Because entrepreneurs have so much more at stake when they make their investments.
In fact, many entrepreneurs feel as if their business decisions are extensions of their own personalities and egos. What’s more, entrepreneurs have often invested their own money, time, and passion into their businesses. As a result, they are more likely to stay put or even up their investments, even when the outcome will never be ideal.
How can entrepreneurs overcome a natural tendency to stick with a losing proposition?
One option is to follow the example of uber-successful entrepreneurs who have tried and failed multiple times before reaching the pinnacle of business success. One such individual is Sir Richard Branson, creator of the Virgin collection of over 350 companies including the amazingly audacious Virgin Galactic—a company focused on space-based tourism.
Branson started in the record business at just the wrong moment. As soon as he had created a network of hundreds of brick and mortar music stores, the iPod hit the market—destroying the market for physical CDs. But Branson stuck with it—longer than he should have—before making a move. As he says in an interview with the GeniusNetwork:
I suspect the biggest mistake that I made was staying in music retailing longer than I should have done. Once you could start down-loading, once the iPod was available, the writing was already on the wall for music retailing. I stuck with it longer than I should have done, and it cost us a lot of money.
So, I think cutting one’s losses is something which is often tough to do, but it’s important to do early on. Rather than wasting away a lot of money, you can actually reinvest that money in creating new jobs elsewhere, rather than chasing a dying industry.
What are you invested in today, that you should possibly move on from? Is your small business loosing money on a poorly planned marketing campaign, or have you spent a lot of time on a new initiative that isn't seeing a return?
Now is a good time to take a hard look at where you are invested in something that isn't paying off—and make the difficult but necessary adjustments for the future.
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