Sunk Cost Fallacy: Avoiding Investment Mistakes

Imagine you’ve started knitting a sweater. You’ve spent hours, bought expensive yarn, and you’re quite far along. Then you realize you actually dislike the color, or maybe the style just isn’t working out as you envisioned. Those hours and the cost of the yarn are what we call sunk costs. They’re already spent; they’re in the past, and you can’t get them back, regardless of what you decide to do next with the sweater.

Sunk costs are essentially expenses that have already been incurred and cannot be recovered. Think of it like paying for a non-refundable concert ticket. Whether you go to the concert or not, you’ve already spent the money. The money is sunk. In business and investment, sunk costs can be significant. They might be research and development expenses for a new product, initial marketing campaigns that didn’t quite take off, or even specialized equipment purchased for a project that’s now struggling.

The problem arises when we let these sunk costs influence our future decisions about a project. Logically, when deciding whether to continue with the sweater, or go to the concert, or persist with a business project, we should only consider the future benefits and future costs from this point forward. What we’ve already spent is irrelevant to whether continuing makes sense now.

However, human psychology often gets in the way. We have a natural tendency to want to justify our past decisions and avoid feeling like we’ve wasted resources. This is where sunk costs can lead to flawed investment decisions. Let’s say a company has invested millions in developing a new software platform. After a year, it becomes clear that the platform is not gaining traction in the market. It’s buggy, users aren’t adopting it, and the competitive landscape has shifted.

A rational decision at this point might be to cut losses, stop investing further, and pivot to a different strategy. However, because of the significant sunk costs, the company might be tempted to continue pouring more money into the project. They might think, “We’ve already invested so much, we can’t just give up now! We need to see it through, or all that money will be wasted.” This is known as the sunk cost fallacy, or sometimes the escalation of commitment.

This ‘throwing good money after bad’ scenario happens because we mistakenly believe that by continuing to invest, we can somehow recoup the sunk costs. But the reality is, those past costs are gone regardless. Continuing to invest in a failing project based on sunk costs is like driving further down a dead-end road because you’ve already driven so far. It doesn’t change the fact that it’s a dead end.

In a proper valuation analysis, sunk costs should be completely ignored. When evaluating whether to continue a project, we should only focus on the incremental future revenues and incremental future costs. Incremental means the additional revenues and costs that will occur if we continue the project, compared to if we stop it. We need to ask ourselves: “Looking ahead, will the future benefits of continuing this project outweigh the future costs? And are there better alternative uses for our resources?”

Consider a construction project that’s significantly over budget and behind schedule. A flawed decision driven by sunk costs would be to continue pouring money into the project simply because so much has already been spent, even if objective analysis shows that the project is no longer financially viable or that the market has changed. A proper valuation analysis would disregard the costs already sunk and focus on the estimated costs to completion versus the projected future revenues and the opportunity cost of using resources on this project instead of others.

To avoid flawed decisions due to sunk costs, businesses and individuals need to cultivate a mindset of forward-looking decision-making. Regularly re-evaluate projects based on current and future prospects, not past investments. Be willing to cut losses and pivot when necessary. It can be emotionally difficult to abandon a project you’ve invested heavily in, but recognizing and ignoring sunk costs is crucial for making sound investment decisions and ensuring resources are allocated effectively for future success.