Today, we’re going to talk about sunk cost fallacy in your business. I’ll address:
- What is it
- Why it happens
- How to avoid it
Everyone is victim of it in some way or another and it’s hard to address it if we’re not aware we’re doing it.
By breaking it down, you’ll learn how to combat our natural tendencies and start making better decisions.
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HOW TO AVOID SUNK COST FALLACY AND SAVE YOUR BUSINESS MONEY
In the 1980s, 2 scientists put together a questionnaire to examine how we were influenced by sunk cost fallacy.
They asked participants to imagine they’d spent money on 2 different ski trips that happened to be on the same weekend. They’d spent $100 to go to Michigan and $50 to go to Wisconsin.
Based on what they knew of each trip, they were told they’d enjoy the Wisconsin trip more.
They were told it was too late to get their money back and they couldn’t do both, so they had to decide which trip they’d go on.
A majority (54%) of respondents said they’d go on the higher Michigan trip despite it being less enjoyable.
54% chose the less optimal trip because the cost was higher… It seems almost absurd to think we’d make such an irrational decision, but we do it all the time.
We go to an event we’re dreading because we paid for the tickets.
We continue with the degree or class because we “made the investment.”
We keep a bad employee on staff because we’ve already trained them (and no telling who we’ll get to replace them).
We pay for a new software (or stick with an old one) and keep trying to make it work for way too long.
What is sunk cost fallacy?
A sunk cost is a cost that has already occurred and that you can’t recover. You’ve paid for it (cash out of your pocket) and you can’t get it back.
When you sign a 3-year lease agreement and no longer need the space after 6 months, the 6 months of rent are a sunk cost. The remaining value on the lease may not be sunk, but could be if there is no way to recover them (such as a sublease).
The fallacy comes into play when you or your company continues forward despite the money already being gone.
I’ve actually seen scenarios where a company kept the office “open” just so they could say they were using it, all the while incurring more costs and digging deeper into the hole.
When you can’t recover the cost, the logical decision would be to continue on without consideration for the previous investment.
This is easier said than done, I understand.
Why it happens
I’m sure we can all recall scenarios where we’ve fallen prey to this fallacy, but it keeps happening.
Why you may ask?
There are many reasons, but I’ve narrowed to 3:
- We’re too emotionally invested. Business and money can be intense, which makes it easy to get emotionally attached to the outcome we desire. This is just deepened when there is a monetary commitment involved.
- We’ve made a commitment (commitment bias) and don’t want to go back on it. Using the office example, when you agree to the lease, you believe in the business outcome tied to that lease. It’s easier to continue forward than to change course. By giving up that office, you’re acknowledging that a past belief or conviction was wrong. By continuing forward, you’re holding hope that the belief or conviction could still be true.
- We desire to avoid losses more than we seek out gains, which is otherwise known as loss aversion. The truth is that losses hurt and linger longer than wins do. If we continue forward with the office, we don’t have to acknowledge the lost money we’ve invested there. It hasn’t failed… yet.
How to avoid it
So, how do we avoid making these sort of mistakes?
Ask: how could I be wrong?
Normally, we look to confirm our beliefs (known as confirmation bias). We discard data that doesn’t align with our belief of what is going to happen. That means when we’ve made the investment of time or money, we ignore data that disagrees with the investment we’ve already made and confirm our investment with even the tiniest shred of data.
Instead, if we turn it around and face the dissonant data, we have a better chance to acknowledge our bad investments and stop ourselves from moving forward.
Include skeptics on the team
If you’re not good at asking yourself the question above, ask someone to join the team who already does this naturally.
It’s easy to avoid or be frustrated by the people who always have to look for the cracks. But, when faced with big time and money investments, including one of these people can help you see your mistakes sooner.
Ask yourself: what am I feeling?
I’ve heard it said that feelings don’t belong in business. The thing is, we can’t completely separate our feelings from us… so it’s unreasonable.
Two of our reasons for this sunk cost fallacy, commitment bias and loss aversion, arise because of the feelings we feel.
By knowing that these biases are out there and acknowledging those feelings, we label and draw attention to it. When we do this, we remove some power from the feeling and can better decouple our decision from our feeling.
Analyze future costs and ignore past ones
Nothing beats a good old financial model. Now, I know some of you might not be as excited about this as I am, but almost anything can be modeled.
And I’m sure you’re thinking it’ll be complicated, but it often doesn’t have to be. The trick is following these 4 steps:
- Write down all the possible scenarios going forward
- Record all the future potential costs with those scenarios
- Create a month-by-month or year-by-year cost analysis for each
- Ignore all previous costs associated with them
Number 4 is really key. If you include prior costs, you’re falling prey to sunk cost bias.
By laying out future cost, you’re creating a hard-to-argue-with analysis that forces you to look at things how they actually are, versus how you want them to be.
Pre-determine under what conditions you’ll reevaluate
Before you start down a path with an investment or a plan, create a set of “stop” rules. By creating these rules beforehand, you remove the “fog of war” effect that happens during an engagement.
While you won’t have all the information you need, and some of the “stop” criteria may not be as bad as anticipated, following these rules will create natural points to reevaluate.
During a project, it’s always difficult to slow down. But by creating these rules and make it a part of the culture, you force reflection and analysis independent of your clouded judgement in the moment.
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If you’re interested in seeing out susceptible you are to sunk cost bias, I came across this 8-question quiz you can take if you’re interested.
THINGS OF INTEREST
- This week I released a podcast episode where I interviewed Jeff Rose, a financial advisor turned content creator. We talk about his money background, his time in the military, and how intentional decisions lead to him selling his financial advisor practice to become a content creator. Listen here.
- In case you missed it, I did an interview with Joshua Becker a few weeks back about his new book, Things that Matter. I’ve been thinking about this more and more and will definitely be writing on it in the future. I think we’re in a new age of work and society where people are going to be desiring their “optimal” life. But, without knowing what truly matters, we’ll choose the wrong things time and again. In our conversation, we talk about the distractions that keep us from what truly matters. Listen here and let me know what you think.
Thank you for reading–see you again next week.
If you’re interested in learning more, here are 3 ways I can help:
- Purchase the Financial Statements Decoded eBook.
- Join the waitlist for my cohort Financial Statements Decoded. Next one is in January!
- Work with me 1-on-1 to optimize your financials and create a financial dashboard that will increase profit (booked through November 2022
