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Sunk cost fallacy
A couple of years ago, we (my business partner and I) were losing money every day running our company. I was thinking about giving up and moving on, but there was always a voice in my mind:
“You’ve come this far, and you want to give up now?”
“What about all the money, time, and energy you’ve spent on the business?”
As creatives and entrepreneurs, we’re forward thinking. We make decisions that lead to a better future by making a sound evaluation of the future gains of our investments and experiences.
Only the reality is that we don’t.Instead, our decisions are tainted by the emotional investment we accumulated in the past. The more time, money, and energy that we invested into something in the past, the harder it is for us to abandon it when things didn’t pan out the way we wanted them to.
It’s not our fault. All of us are wired with this mental flaw. And there is a name for it: The Sunk Cost Fallacy.
The truth is, regardless of whether or not I give up that business or not, I’ve lost all the money, time, and energy. They are not coming back even if I decide to stick to the failing business. And this happens more often than we think in our day-to-day life. It’s one of the many mental flaws we — human beings — have, that cause us to make bad decisions.
The pressing question is: Why? Why is it so easy for us to fall prey to the sunk cost fallacy even when we’re aware of it?
In their paper “Mnemonomics: The Sunk Cost Fallacy as A Memory Kludge”, economic theorists Sandeep Baliga and Jeffrey Ely argue that human beings have a limited capacity to remember the original reasoning behind their decisions.
The information could be lost when that capacity is exceeded. Thus, we need a mental placeholder to remind us of why we decided something such as a vision board in your room or a to-do list on your smartphone.
It’s a shorthand way for us to remember something that we might forget. Putting the sunk cost bias into the context, the theory explains that you made a decision early on, and it cost you some sort of investment. Later, you forget the details, but you remember the cost.
However, their research suggests that we will still commit this mental error even when our memory capacity isn’t fully occupied. As it turns out, there is more to do with it than just our memory.
When giving a chance to gain $20 by risking their own $10 on pure possibility (like flipping a coin), most people refuse to take the bet because they value their $10 more than the possible gain of $20.
In other words, we tend to have a much stronger preference for avoiding than for acquiring gains. And this has to do with why we keep committing the sunk cost fallacy. According to researchers Daniel Kahneman and Amos Tversky, people fall prey to the sunk cost fallacy due to loss aversion.
When we invest our money in business, our energy on a creative project, or our time and emotions on a relationship, we expect to gain something valuable in return. Even when the evidence to the contrary is clear, we continue to believe that our investment will eventually pay us back. This is based on sunk costs which allows us to avoid what social psychologist Dan Ariely calls “the pain of paying.”
We’re wired to stay consistent with what we think and do. It’s a part of the evolution to shortcut our decision-making process.
These mental shortcuts were useful a few hundred thousand years ago because environment changes slowly. And thus, we’re wired to make decisions this way.
However, today, our surroundings are changing rapidly. Something that seems insane right now could be seen as normal six months later. Something helpful today might become damaging 17 months later.
In order to abandon a failed investment of money, time, and energy, we need to admit that we made a mistake in the first place. This is much harder to do compared to sticking to past decisions even if our gut feelings tell us otherwise.
It only gets harder to admit mistakes when we face external pressure and consequences like lost reputation, investor’s support, and marriage.
The sunk cost fallacy doesn’t only cause us to make poor daily decisions and financial decisions, it affects our lives on a larger scale because the bigger the decision, the easier we fall prey to it.
The fact is that we can’t remove this bias entirely because it was hardwired in us during evolution. However, there are a few ways we can reduce the times we make decisions based on sunk cost.
The first step is to implement a better memory placeholder to remind ourselves of the big decisions we’ve made in the past. For example:
These memory placeholders do two things:
The next step to overcome this bias is to allow ourselves to make mistakes. Make it a habit of being okay with making mistakes and move on.
Again, it’s hard to admit that we’re wrong even when we know it. However, the willingness and ability to embrace mistakes and learn from them is one crucial element to making better decisions.
If you want growth, you need to tell yourself the truth, even when the truth is harsh and uncomfortable.
In stoicism, mistakes are something that happened in the past. And the past is something we can no longer control, change or influence. Therefore it makes no sense to worry about mistakes. Instead, learn from them and move on.
Allowing ourselves to make mistakes is hard because there are always fears involved. To better face your fears, visualize the worst-case scenario and list them down. Eventually, it isn’t that bad after all and we learn to face it directly.
Next, we can train ourselves to detach from the past by practicing mindfulness. Learn to ask better questions when making decisions - especially big ones:
Mindfulness makes us less likely to make decisions based on emotions and helps us focus on things that matter the most.
Meditation is an excellent way to start training our mind. It helps us to focus on the present, to lead our attention in the right direction and to calm ourselves down in the sea of urging decisions.
A fundamental truth is that we’re not perfect. In other words, we’re not ideal for the environment around us. Our brain has been evolving since the past 500,000 years to help the species survive while the environment has changed rapidly in the past 500 years.
There is no perfect strategy to cure the sunk cost fallacy once and for all. It’s been hardwired into our behavior for hundreds of thousands of years of evolution. Besides, we have no way to justify that all sunk cost is bad. It’s a critical part of information that aids our decision-making.
The goal shouldn’t be getting rid of the sunk cost bias and ignoring sunk costs as a valuable piece of information when making any decision. Instead, we can strive for making better decisions by exploring multiple angles and sources of information to minimize our tendency to base them on past financial and emotional investments.