sunk_cost

Know Your Nuggets: Sunk Cost

bob_sullivan
Bob Sullivan
Writer

Editor’s Note:  The sunk cost fallacy is one of the most widely seen and easily recognizable behavioral principles – it impacts personal, corporate, investor, workplace, travel decisions and more. Don Henley even once told me, “Don’t look back, you can never look back.”  Since that was a ballad about summer, which is now ending, I find his advice not just profound, but timely.  And since I’ve now put a lot of time and energy into forcing his earworm of a song into this intro to our latest Know Your Nugget principle, I’m going to stick with it until the end, no matter how awkward it may get. That’s sunk cost. So is this.

 

You get bad news during an oil change about your old clunker: your transmission is on its last legs. The mechanic says you'll likely end up stranded soon if you don't spend $4000 on repairs. Maybe it's time to get a new ride, the honest mechanic suggests.

"I can't do that," you reply. "I spent $1,500 on a new brakes and tires last year. I can't waste that money."

Perhaps it's a good idea to lay out the cash for a new transmission, but probably not: the $4,000 is likely better spent as a down payment on a new car. But many (less honest) mechanics make their living because car owners have this same reaction: They "throw good money after bad," my father, an amateur mechanic, liked to say.

It's never easy to decide when to repair an old car vs. when to buy a new one. But using last year's repair bill as a guiding force is never a good idea. That money is gone; you can't recover it by throwing more money at your clunker. Economists would say the $1,500 spent on repairs is a “sunk cost.” If $4,000 could guarantee safe driving for another couple of years, than perhaps a new transmission might make sense. But the $1,500 spent last year should have no bearing on today's decision.

That money is gone; you can't recover it by throwing more money at it.

But it often does. Human nature and behavioral experiments have shown myriad ways that people can't help themselves; we can't stop irrationally invoking the past when making decisions about the future. If you've ever waited for a bus that never showed and told yourself, "Well, I've waited this long, I can't waste that time and call a taxi now," you've suffering from the sunk cost fallacy.

There are plenty of examples. Many people stay in bad jobs or in unhappy relationships merely because they think leaving would turn their investment into “Wasted Time," as the Eagles sang in their 1970s hit song – as if only in leaving, the time becomes wasted. (Editor’s note: You thought you’d escaped old musical references, didn’t you? Nope.)

We can't stop irrationally invoking the past when making decisions about the future.

Investors suffer from the sunk cost fallacy all the time. When a stock they own drops from $50 to $25, there's a natural urge to hold on until the stock climbs back to the original purchase price. That's folly; all that matters in investing is the future. Last year’s stock price doesn’t really tell you much about next year’s price. Still, it serves as a kind of anchor or frame for naïve investors who are bad at cutting their losses.

Corporations fall into sunk cost traps all the time, too. Hal R. Arkes and Catherine Blumer ran a famous thought experiment for a paper published in 1985. Here’s the scenario: An airplane maker plans to spend $10 million researching a new plane, but when the study is 90% complete discovers that a competitor has just released a better unit that will likely soak up all potential market share. Knowing that, an overwhelming majority said the firm should still spend that final 10%, the last $1 million, researching the new plane anyway.

Corporations fall into sunk cost traps all the time.

There are plenty more subtle versions of the sunk cost fallacy, too. People who order too much food tend to overeat so their money isn't wasted, waistlines be damned. We do this with time, too. Buy a ticket to a baseball game months in advance, and you're likely to go even if you just don't feel like it – or you get a better offer – when game day arrives. Theater-goers who buy season subscriptions go to more shows, even if they don’t really want to.

Plenty of other behavioral concepts overlap with sunk costs, perhaps none more directly than loss aversion which we’ve covered earlier. People really hate losing, so we’ll do pretty crazy things to avoid the feeling of loss. 

Don't feel badly; lots of people fall for the sunk cost fallacy. Mice and rats, do, too. And so do... economists. Perhaps the most entertaining part of Blumer and Arkes’ work was this finding: “The sunk cost effect was not lessened by having taken prior courses in economics,” the authors found.

Plenty of other behavioral concepts overlap with sunk costs.

A combination of rat-like and economist-like behavior can be seen in perhaps the ultimate sunk cost experiments – something called the dollar auction. This experiment highlights “irrational escalation.” Briefly, in a dollar auction, a room of people are invited to bid on $1 – starting at as little as 1 cent. But it’s a special auction: There’s a catch. The runner up has to pay. Theoretically, the winner could walk away with 99 cents, but that never happens. Instead, the auction runs, escalates towards 70, 80, and 90 cents, and pretty soon the second-highest bidder gets into a pickle. Backing out means losing nearly $1.  Worse yet, the bidding inevitably soars past $1, as no one wants to pay. Like a bad game of monopoly, it only ends when someone decides they’ve had enough, and they’ve lost more than they’d ever hoped to win.

The dollar auction shows how individual, rational steps can ultimately lead people down the road to perdition. Fixing the brakes makes sense. Buying new tires makes sense. But when does repairing the car no longer make sense? It’s also easy to see how irrational escalation trips up many a Wall Street merger. Yahoo once paid $1 billion for Tumblr, largely because then-CEO Marissa Meyer was worried about losing the company to Google or Facebook. Tumblr was recently sold off for less than $3 million.

The sunk cost fallacy has plenty of workplace implications. The most obvious: Don’t let emotional attachments to yesterday’s decisions impact today’s choices. There are plenty of practical ways to implement this. Here’s a simple one: Avoid prepaying for things as much as possible. You won’t feel obligated to go to the theater if you didn’t buy the subscription. On the other side of the coin, getting consumers to commit ahead of time (with money, or with time) is a great way to make sure they follow through.

Don’t let emotional attachments to yesterday’s decisions impact today’s choices.

And here’s a fresh spin on that thought: We sometimes honor other people’s sunk costs, too. Professor Christopher Olivola of Carnegie Mellon University recently studied what he called the “interpersonal sunk-cost effect.” Imagine you were lucky enough to have two friends gift you a vacation weekend at the same time. Olivola’s research suggests you would opt to pick the more expensive trip, even if you’d rather go to the less expensive place. That’s a powerful effect brands could learn to use.

The traditional framework to avoid the sunk cost fallacy is to adopt a “let bygones be bygone” mentality, and that’s certainly a useful notion. But most of all, be aware that even after reading this story, you’ll still probably fall for it. The best you can hope for is a bit more self-awareness and a bit better mindset that prepares you to cut your losses when necessary. I’d go on, but I have to go to the repair shop to get my old car with its new transmission.

bob_sullivan
Bob Sullivan
Writer

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