Sunk Cost Defined
A sunk cost is an expenditure that has already taken place and can’t be reversed. For example, if you spend money on a clothing shopping spree today and haven’t worn the clothes yet, it’s not a sunk cost because you can take the clothes back to the store and refund them. Once you can’t reverse the decision to any significant degree, the expenditure or action becomes a sunk cost.
Common examples of sunk costs:
- when you invest in a stock and the price drops
- when you lose money in a hand of poker or any round of gambling
- when you buy something you rarely or never using but can’t refund or resell
- when you buy a nonrefundable ticket to a movie
People often think of monetary expenditures when considering sunk costs, but there are many psychic types of sunk costs that exist as well. For example, picture costs like:
- Investing time
- Losing dignity
- Experiencing anger
- Undergoing drama and emotional rollercoasters
- Experiencing depression
- Undergoing crushing stress and anxiety
- Expressing vulnerability
- Choosing monogamy and forgoing other mating opportunities
- Revealing deep, emotional secrets about yourself and your past (allowing someone access to your inner world is a huge sacrifice because you lose much of your protective armor and risk betrayal)
- Having arguments (huge investment of mental and emotional energy)
- Intercourse (especially for women, who are often culturally conditioned to believe that their dating value drops with each new sexual partner)
The former set of examples are costs we incur while making financial investments. The latter are costs we incur while making emotional investments. Both types of costs are sunk costs however because once we spend them, we can’t unspend them, regardless of whether they pay off and prove to be good investments.
Some sunk costs can fall under both financial and emotional categories, like the money you spend on someone you’re dating.
Sunk Costs and Loss Aversion
In an earlier raw concept, we discussed loss aversion, and how people are programmed to focus much more on avoiding losses than maximizing gains.
Sunk costs mentally register as losses, which is why we try so hard not to accept them and avoid admitting to ourselves when a sunk cost didn’t pay off, because if we admit that a sunk cost didn’t pay off returns, then we have to admit that we failed to avert a loss, something very hard for humans to accept.
Sunk Cost Traps
Here are examples of three logical traps involving sunk costs: the sunk-cost dilemma, the overly optimistic outlook, and the personal ownership bias.
The sunk-cost dilemma is what people mean when they describe “throwing good money after bad.” It’s a situation where you take into account the resources you’ve already expended in deciding whether or not to commit more resources in the future. Realistically, the resources you already expended have already been spent, and there’s no getting those specific resources back. So you shouldn’t take them into account when making future decisions. But we often can help falling into this trap.
a dilemma of having to choose between continuing a project of uncertain prospects already involving considerable sunk costs, or discontinuing the project. Given this choice between the certain loss of the sunk costs when stopping the project versus possible – even if unlikely – long-term profitability when going on, policy makers tend to favour uncertain success over certain loss.
As long as the project is neither completed nor stopped, the dilemma will keep presenting itself.
For example, say we spend $12 on a nonrefundable ticket to a 3 hour movie. 15 minutes into the movie it becomes obvious that the movie is going to totally suck and be painful to watch. Because we committed $12 and 15 minutes to the movie already, we don’t want to “waste” that money and time expenditure, and we ride out the final 2 hours and 45 minutes, having an excruciatingly bad time. The problem is, if the movie sucks, that nonrecoverable $12 and the 15 minutes we already spent is going to qualify as a waste anyway, regardless of whether we finish watching or not.
The proper thing to do is just cut our losses and walk out. If the $12 and 15 minutes have already been spent and are nonrecoverable, why add an avoidable 2 hours and 45 minutes to our wasted expenditures.
Other examples are refusing to stop gambling because you are deep in the hole and don’t want to stop while you’re down, thereby accepting the loss. Or when you buy a stock or a house and the value continues to go down, and all signs show the value isn’t likely to go up, but you still refuse to sell because you feel selling under those conditions would be admitting a loss. So you continue to ride it all the way to rock bottom. You can read more examples here.
People think from this phenomenon that being loss averse is the problem. But these mistakes are really errors in framing and future orientation. For example, if instead of phrasing the decision to throw good money after bad as the loss aversion option (“I don’t want to lose what I already spent,” you phrased the decision to cut your losses as the loss aversion option (“I want to avoid losing any future resources in this endeavor”), you’d make the right choice. The problem isn’t being averse to loss, it’s being averse to the wrong type of losses: past, nonrecoverable losses, rather than future, preventable ones.
Overly Optimistic Outlook. Another logical trap involving sunk costs is that the more resources people have invested in an endeavor, the more irrationally optimistic they make themselves about the future payoff of that endeavor. There was a study in 1968 by Knox and Inkster where they surveyed people who already bet $2 on a horse race and people who were about to bet $2 on a horse race, and the people who already made their bets became much more confident that there horse would win. Also called post-decision dissonance.
Level of Personal Accountability. If someone feels personal accountability for the sunk costs, or takes mental ownership for the bad decisions, they are much more likely to refuse to reverse course. For example, if you were the person at your company who was responsible for deciding to make a bad investment, you’d be less likely to reverse the decision to and accept the sunk costs. However if you were a VP at the company reviewing the decisions of another executive of the company, you wouldn’t find it as difficult to reverse the decision and cut your losses, because you don’t feel personally accountable for running up the sunk costs.
The examples used have been primarily financial transactions and monetary sunk costs, but take the time to figure out the parallels in how these concepts apply also to the psychic sunk costs we accrue in our personal relationships with family members, friends and lovers. It makes a lot of the counterintuitive relationship dynamics we observe every day suddenly make a lot more sense.
The Personal MBA: Master the Art of Business by Joshua Kaufman is a practical business book that gives many examples of sunk-cost traps.