You've already made the investment, so quit fretting.

I'm serious.

That money is long gone.

Instead, look forward.

Today we talk about sunk cost bias.

1. What it is
2. Why it happens
3. How to avoid it

But first, our sponsor.

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How You're Sabotaging Your Business (Sunk Cost Bias)

Let me run a scenario by you.

Say you somehow managed to put a deposit down on two different ski trips (insert your favorite hobby) that happened on the same weekend. You can’t get the deposits back and can’t go on both trips.

The deposit for the Location A trip was $250 and because of factor x you’re guaranteed to enjoy that trip more. But the deposit for Location B was $500, meaning you’ll lose more money if you go to Location A.

Which trip are you going on?

While you may have answered Location A, the majority of participants in a 1980s study chose Location B, the less enjoyable one.

Yes, I’ll repeat: the majority chose the less optimal trip because the cost was higher.

We can’t get the money back, so choosing the more enjoyable options should be automatic, right?

It seems absurd to make this sort of 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.

This is known as sunk cost bias or fallacy and is something that costs businesses tons of money each year.

Today we’re going to dig into what it is and how to avoid it.

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:

1. We’re too emotionally invested. Business and money are complicated, which makes it easy to get emotionally attached to the outcome we desire.
2. We’ve made a commitment (commitment bias) and don’t want to go back on it. Revisiting the office lease example from above, when you took out the lease, you’ve made a commitment to your team or the lessee. By vacating the office, you are breaking a commitment to them and forced to acknowledge a failure.
3. Loss aversion (our desire to avoid losses is more than our desire for gain). Losses end up in our DNA, while wins are quickly forgotten. By holding onto the office, you don’t have to acknowledge the sunk cost or lost money. 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?

Our first instinct is to look for evidence confirming our beliefs or decisions to be true, which is known as confirmation bias. We’ll often discard data that doesn’t align with our belief without realizing it, which colors our decision-making.

We ignore data that disagrees with our decision and look for data that confirms it, even if by the tiniest shred.

Instead, if we turn it around and face the dissonant data, we are forced to acknowledge our bad investments and will make better decisions.

Include skeptics on the team

Sometimes we can’t get past our own bias, so we have to recruit someone who can.

Having a person on the team who is a natural skeptic can serve an important role in bringing up objections you’re quick to ignore.

By being forced to address these objections, you’re forced to do the mental work that will result in better decisions.

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?

We can’t remove feelings from decisions, as much as we try. So, instead of ignoring them, it’s best to acknowledge them.

Is it creating anxiety? Lean in and ask why.

The sunk cost fallacy is driven by our feelings specifically, commitment bias and loss aversion, so to properly the right decision going forward we have to address those feelings.

By knowing that these biases are out there and acknowledging those feelings, we can label it and draw attention to it. When we do this, we remove some power from the feeling and can decouple our decision from our feeling.

Analyze future costs and ignore past ones

This is the absolute key of sunk cost fallacy: ignore the previous cost that you can’t get back.

Easy, right? So let’s move on…

I know it’s hard.

The best way to do this is to play out the financial scenarios.

1. Write down all the possible scenarios going forward
2. Record all the future potential costs with those scenarios
3. Create a month-by-month or year-by-year cost analysis for each
4. 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.

Sure, you never forget the sunk cost. But it’s hard to ignore hard numbers in that analysis.

Pre-determine under what conditions you’ll reevaluate

The “fog of war” is real in business. We saw it with COVID-19. A lot of businesses made drastic changes that came back to bite them. They laid off and then had to rehire. They sold equipment then had to rebuy at a higher price. They cut budgets and delayed things they could have afforded.

To avoid these mistakes, do two things:

1. Document your decisions when you make them. They why and assumptions you’ve made.
2. Create a set of “stop” rules when you’ll re-evaluate your decision.
3. Pre-decide your actions at different stop points.

When you get to “stop” criteria, conditions may not be as bad as anticipated, so you still have the freedom to act as you think is best in that moment. But by pre-deciding the decisions and creating a plan, you remove some of the bias.

This also forces you to stop and reflect during bad times. It’s often easy to move even quicker and let decisions languish too long. By creating these “stop” points, you force yourself to slow down and actually re-evaluate your decision.

If built into the culture of the business, it can completely transform a business.

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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.

Can you think of a time when you fell prey to sunk cost bias? Reply and tell me about it!

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