If you scan the bestseller lists these days, you find more than a few books focused on applying the principles of economics to everyday life. While they make for interesting and even illuminating reads, the problem with most of them is that, in the words of Kiplinger blogger Andrew Feinberg, "Standard economics doesn't comprehend irrationality." That is, economics is a logic-based study, and assumes that utility maximization is the sole decision making variable among human beings. Decisions that fail to abide by this single-minded focus confound standard economic reasoning. According to Feinberg, behavioral finance is the sole academic discipline that explains the frequently irrational actions of investors, and the concept of the sunk-cost fallacy is one of the field's primary foundations.
Sunk costs are investments that have already been made and cannot possibly be recovered, regardless of the efforts, strategies and outcomes of any future endeavors. They are the living flow of the proverbial water under the bridge, real-world affirmation that what is done cannot be undone. And yet, people of even the highest intelligence and the ivyest of academic backgrounds have difficulty resisting the lure of the sunk-cost fallacy.
Have you ever overeaten at an all-you-can-eat buffet because you wanted to make sure to get your money's worth? Have you ever sat though a terribly boring or, even worse, offensive movie because you had already bought the ticket? If you have done either, or anything similar, then you have succumbed to the sunk-cost fallacy.
But those are relatively harmless examples of the acquiescence to the sunk-cost fallacy. The stakes are dramatically higher in the professional arena - and the difficulty in avoiding the trap is considerably greater - because the ensnaring factor is in fact the very personality characteristics that foster success. Entrepreneurs and business managers are internally driven by a combination of perseverance and a self-belief which fuels their engines of achievement. They embody such traits as hard work and unconditional commitment, which to them are not clichés or mantras but the essential texture of the fabric of their being. They inculcate the words of George S. Patton, who insisted that "You're never beaten until you admit it." This never-say-die frame of mind is enthusiastically embraced at all levels of society, from union halls to Wall Street, from urban streets to the ivory towers of academia. Our culture salutes achievement through perseverence, regaling in the accomplishments by industrious underdogs and rags-to-riches success stories.
These traits typically propel the individual towards the success of his or her endeavor. However, when it comes to recognizing sunk costs and knowing when to throw in the towel, this innate passion interferes with the intelligent and effective decision making process. If unchecked, the inability to restrain from reinvesting anew in impossible situations inevitably yields negative results.
In particular, when sunk costs encounter the human aversion to loss and waste, disaster looms. For example, it is not atypical of someone who purchased a stock at $100 only to watch it fall to $70, and refuse to sell on the grounds that they will wait until the stock returns to $100 so that they don't lose on the investment. Even as the stock continues to free-fall, some investors, used to succeeding through effort and perseverance, simply can't sell and accept a loss. In market lingo, focusing on the $100 purchase price is known as "anchoring" and is an ever-lurking trap for investors.
One great example of anchoring takes place almost every day in the sports world, in the form of highly paid but underperforming veterans who are kept in the lineup ahead of younger, more productive, but less costly players. In these cases, team management feels the need to justify their huge contracts, and only in the rarest of circumstances is the more expensive player replaced, an act which is tantamount to a general manager's public confession of an error in judgment.
Another example of anchoring occurs when two people involved in a fading or deteriorating relationship resist breaking up because they have invested too much time and effort and don't want to be seen as a failure. In this case, they are anchored to the original hopes and expectations that characterized the earlier, happier times in the relationship, and don't want to admit that those days and feelings may never return. The behavioral financialist would certainly recognize in this relationship real-world evidence of the sunk-cost fallacy.
The rare ability to not only distinguish a sunk cost from an opportunity requiring further investment but to unemotionally act on the basis of this distinction is the unmistakable mark of the truly exceptional executive. Anything less can result in significant financial loss, or taken to its extreme, bankruptcy. And when we shift from the world of commerce to the political and military, the sunk-cost fallacy can cost hundreds, even thousands, of lives.
Unfortunately, many of even the best and most successful executives lack the objectivity and personal distance to recognize a sunk cost. As a result, ineffective investments become, in effect, barriers to exit. For example, companies that commit to advertising strategies and don't see the desired results often feel forced to continue pouring additional funds into the campaign to achieve some kind of return in order to justify the initial spend, which remains irretrievable.
Sunk costs within your business can take many forms, including financial investment, management effort, corporate commitment, personnel, and perhaps most dangerous of all, time. Conscientious managers need to understand and be prepared to deal with the various potential manifestations of the sunk-cost fallacy within their operations, which can include:
- Press operators who struggle in vain to get a particular job to run correctly, wasting time, effort and money. They must recognize that just because they have already invested materials, time and effort into the job does not in any way guarantee the success of the run. The fact is, blind confidence that trial and error will succeed on certain jobs will inevitably result in a disproportionate loss.
- Pursuit of a new product or market based on the number of hours invested by decision-making personnel in research and development, and not on the basis of what is best for the company.
- Retaining incompetent workers on the basis of inertia and an unwillingness to admit a poor hiring decision or concede that the training and compensation to date was wasted. Cutting the cord with poorly performing personnel is better done sooner, rather than later.
- Following courses of action on the basis of public commitment, even after subsequent events or facts arise which demand a different approach. This is an area of particular danger to politicians, who all too frequently paint themselves into corners by loudly taking positions from which they feel they can't move. The fear of being labeled a "flip-flopper" is in fact just another example of the sunk-cost fallacy.
When attempting to recognize whether you are dealing with a sunk cost or a legitimate opportunity for continued investment, the key question to ask is this: Will additional investment enable you to build on the base of previous investments to achieve success with lower risks or at a lower cost? If so, then those previous expenditures are alive, and not sunk. However, if you gain no real benefit going forward from any of the prior investments, and you have other investing options that will produce better returns on your next spend than furthering the current investment, then you must bite the bullet, eat a little crow and admit that the investment to date is a sunk cost. No one likes acknowledging error. It stings. But I guarantee that it will sting a lot more after you throw more good money after the bad.
Sunk costs is a concept that should be taught on the first and last day of business school, and should be part of any employee training program. It is a critical element to truly lean thinking, as it reinforces the need to think purely in terms of value and waste. The only return you can achieve from a sunk cost is the learning experience from the fruitless endeavor. As the Dale Carnegie quote goes, "The successful man will profit from his mistakes and try again in a different way."