Sunk Cost Fallacy (Part 1)

Sunk cost fallacy is a term that I believe many people have come across. It’s been used to describe a way of thinking that impacts various areas of our lives, but what does it actually mean and what are people trying to say when they bring it up? 

First, let’s define a fallacy. A fallacy is basically an error made in one’s reasoning that causes an argument to be logically invalid even if its conclusion might make sense on the surface. I want to draw emphasis to the idea that the invalidity is from a logical standpoint, and I do this because we are not perfectly logical beings. We do not go through life with 100% logical efficiency in mind (we aren’t robots), but often we are acting and reasoning with our own interests, desires, and values in mind. This is not necessarily a bad thing. In fact, it’s a pretty normal, human thing to do. But, it does make us prone to viewing things with a distorted lens in hopes of validating our beliefs and feelings. Hence, the existence of fallacies.

Now, let’s define sunk cost. This refers to a cost that has already been incurred and cannot be recovered. Because these costs have already been paid and nothing can be done to retrieve them, logically, they should not influence decisions made about the future. From a purely rational standpoint, this makes perfect sense. The amount I invested into something or someone previously, should not influence how much I invest later. It should be dictated by something else like my current financial situation or the returns I realistically expect to receive from investing. However, things don’t always play out with this level of logic.

We can now define sunk cost fallacy as a way of thinking where someone bases their decision to continue investing in something/someone on the fact that they have already invested previously. On the surface, this doesn’t seem like a problem though. If I saw value previously and have already invested, why shouldn’t I continue? Especially, if I’m expecting a return? Well, let’s break this down by considering two scenarios. A “good” one, where there is a “positive return on investment” so to speak. And a “bad” one where there are no returns, but rather a loss.

A quick note: for the sake of simplicity and consistency, I have been using the language of economics. But sunk cost fallacy is used to not only describe economic financial or business matters, but also relational matters. The language I use here is not meant to promote the idea of transactional relationships, but is meant to serve as one way of potentially evaluating the quality of the relationships we have with others.

That being said, let’s look at the good scenario now. Perhaps you’ve been investing into something for 3 months and have yet to see returns, but continue to invest anyway. Then, after 6 months of continued investments, you receive a good return on your investments. Now look at the bad scenario. You’ve invested for 3 months and nothing. Then after 6 months, you are thanked for your generosity, and told that you will not be receiving anything further for your investments (I don’t know if this makes any economic sense but just go with it).

Both scenarios start off the same, and you make the same decisions in both scenarios, so why do they have different outcomes? Sunk cost fallacy says that “because I already poured into this, I should continue so it doesn’t feel like I wasted my money, and surely I’ll get something back right?” For the situation where things turned out okay, it would be easy to think this is valid. But is the continued outpouring of resources what resulted in the returns? No, it’s not, as evidenced by the bad scenario. 

What if I tell you that the investment in the “good” scenario was into a small business that was intentional about improving their product and training their employees, while the “bad” scenario’s investment was a small business that was not diligent in making improvements and ultimately went under. With the added context, it’s easy to see that simple perseverance isn’t what resulted in a good outcome. If the person in the “bad” scenario had viewed the situation for what it was, an unrecoverable investment that was already made into a now declining company, then they could have avoided losing more than what was already gone. Likewise, the “good” scenario may have been made even better if the investor recognized the improvements and invested more, if they had the means to do so.

It is easy to see the impact of sunk cost fallacy in this situation where both outcomes are made plain and the contexts are known. It becomes clear how a present/future focus over a past focus can help us make better decisions. But it isn’t always this simple or clear. I’d like to use my next blog post, (as I am told that people don’t like long readings), to outline some more complex situations where sunk cost fallacy impacts decision making. I imagine that some of you reading have already benefitted from this breakdown and will run with it. But for those who can’t wait for the next post and want more examples, there are several short videos on YouTube about it, so feel free to take a look and learn a little more!