Cognitively Yours 1.30

Raja R, Author

"The sunk cost fallacy may in part occur due to loss aversion, which describes the fact that the impact of losses feels much worse to us than the impact of gains."

Let us consider the following real-life examples:

1. Team selection and sunk costs

With IPL season just behind us, imagine a team which had spent huge money on a player. Suddenly, he goes out of form and not playing well. Did the team bench him ignoring the costs spent on him or played him every game as they had already spent on him.

2. Bad concerts and sunk costs

You go to a concert paying an exorbitant price for the ticket. The concert is unbearable. Do you listen to the concert fully wasting precious time as you have already paid for the ticket or leave the venue to utilise you time on more fruitful endeavours. Will your decisions be different, if the concert is free.

3. Break ups are hard

People often decide to carry on unhappy marriages. None is willing to accept that they picked up wrong and wasted a sizeable part of their lives.

4.Over eating and sunk costs

You go to a buffet and you end up overeating. You want to make up for the money spent, little realising that you won’t get your money back and not realizing the ill-effects of overeating.

5. Investing in equities - Sunk costs

“When you find yourself in a hole, the best thing you can do is stop digging”. Many a time, we fall in love with a stock - one sided love as the stock does not know that you own it and stick to it despite change in fundamentals and narrative. As you have bought the stock at a higher price, you do not want to accept the mistake and cling to it to lose more.

6. Career decisions and sunk costs

If you have worked in a particular job for five years, there will be hesitancy to switch paths as the experience gained in that industry may go futile and thinking that you may have to start from the scratch again.

7. Shopping and sunk costs

We go to a mall to buy something specific travelling 20 kms. If the said product is not available, we buy something else lest our efforts to reach the mall go waste.

8. Gambling and sunk costs

If you are on a casino and if you have lost 80 percent of your budgeted money for gambling, the natural tendency is as you have lost so much, there is no harm in gambling the rest on it too.

9. Reward points and sunk costs

You get messages from credit card/ banks that your reward points will expire soon and advising you to redeem them. To ensure that reward points do not go waste, you tend to redeem them to buy something which you do not need and in the bargain pay handling charges for it.

10. Electronic goods and sunk cost

For the smartphones which we use, we replace the batteries frequently at a cost. Once we replace the batteries if the smart phone breaks down, we prefer to repair them without doing a cost-benefit analysis of repairing as against buying a fresh one.

11. Positive aspects of sunk cost

You enrol for a gym. Instead of doing exercises at home without spending money may at the outset look like a wasteful expenditure. But just because you have spent the money you tend to go to gym and exercise.

The common thread in all these examples is sunk cost involved and sunk cost fallacy prevents us from taking the rational decision.

Jason Zweig, the Wall Street Journal investment columnist, worked with psychologist Daniel Kahneman on writing Kahneman’s book “Thinking, Fast and Slow”. Zweig mentions about Kahneman “Nothing amazed me more about Danny than his ability to detonate what we had just done”. He and Kahneman could work endlessly on a chapter, but the next thing you know, Kahneman sends a version so utterly transformed that it is unrecognisable. It begins differently, it ends differently, it incorporates anecdotes and evidence you never would have thought of it, draws on research thy you’ve never heard of.

“When I asked Danny how he could start again as if we had never written an earlier draft, Kahneman said “I have no sunk costs”.

Sunk costs - anchoring decisions to past efforts that can’t be refunded - are a devil in a world where people change over time. They make our future selves’ prisoners to our past, different selves. Financial goals embarked when you were a different person should be abandoned mercilessly rather than putting them on life support and dragging on to minimise future regret.

A rational decision maker is interested only in the future consequences of current investments. Justifying past mistakes is not among his concerns. The decision to invest in a losing cause when better investments are available defies logic. Imagine a company has already spent Rs 50 crore on a project. The project is behind schedule and forecasts of its ultimate returns are less favourable than at the initial planning stage. An additional investment of Rs.60 crore is required to give the projects a second life. An alternative proposal is to invest the same amount in a virtually new project that currently looks likely to bring higher returns. What will the company do? The company in all probability will prefer to throw good money after bad rather than accepting the humiliation of closing the account of a costly failure.

The sunk cost fallacy means that we are taking irrational economic decisions because we are factoring many influences other than the current alternatives. This happens because emotions tend to trump over logic.

The sunk cost fallacy may in part occur due to loss aversion, which describes the fact that the impact of losses feels much worse to us than the impact of gains. We are more likely to avoid losses than seek-out gains. We may feel that our past investment will be ‘lost’ if we don’t follow through on the decision, and decide based on loss aversion rather than consider the benefits that would be gained, if we did not continue our commitment.

How to avoid it

Daniel Kahneman in his book “Thinking, Fast and Slow” explains this with an example and provides advise how rational decisions can be taken.

Consider the following pair of problems:

1) A woman has bought two $80 tickets to the theatre.When she arrives at the theatre, she opens her wallet and discovers that the tickets were missing. Will she buy two more tickets to see the play?

2) A woman goes to the theatre intending to buy two tickets that cost $80 each. She arrives at the theatre, opens her wallet, and discovers to her dismay that the $160 with which she was going to make the purchase is missing. She could use her credit card. Will she buy the tickets?

Respondents who see only one version of this problem reach different conclusions depending on the frame. Most of them believe that the woman in the first story will go home without seeing the show if she has lost tickets, and most believe that she will charge tickets for the show if she has lost money. The different frames evoke different mental accounts, and the significance of the loss depends on the account to which it is posted. When tickets to a particular show are lost, it is natural to post them to the account associated with that play. The cost appears to have doubled and may now be more than the experience is worth. In contrast, a loss of cash is charged to a “general revenue account” - the theatre patron is slightly poorer than she had thought she was, and the question she is likely to ask herself is whether the small reduction in her disposable wealth will change her decision about paying for tickets. Most respondents thought it would not.

The version in which cash was lost leads to more reasonable and rational  decisions, it is a better frame because the loss, even if tickets were lost, is “sunk” and hence ignored. History is irrelevant and the only issue that matters is whether to attend the show or not. The relevant question to be asked to the person who lost tickets “Would you have bought the tickets if you had lost the equivalent amount of cash? If yes, go ahead and buy new ones.”

Broader frames and inclusive account generally lead to more rational decisions. In short, while it is difficult to overcome inherent cognitive fallacies, if we are aware of the sunk cost fallacy, we can try to ensure we are focusing on current and future costs and benefits instead of past commitments. We should focus on concrete actions instead of the feeling of wastefulness or guilt that accompanies dropping an earlier commitment, as studies have shown that when we are deterred from making decisions based on our emotions, the effects of the sunk cost fallacy are reduced.

However, it is difficult for us to ignore our emotions as they are powerful influences on our decisions. Instead, we can turn to technology to help us make decisions. Information technology systems make rational choices and are not impacted by the chain of decisions that came before.

References: Thinking, fast and slow by Daniel Kahneman, The Psychology of Money by Morgan Housel, 20 real life examples of the sunk cost fallacy published by Value Tortoise.

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