Let’s pretend for a second that you’re in charge of a chocolate bar company.
Over the past year or so, you’ve had your team working on a new chocolate bar. It’s cost you a million bucks so far, but you’re nearly done. For another $100,000 of work, your chocolate bar will be ready to sell.
Then you get some bad news. Another company is about to release their own chocolate bar. It’s going to be more delicious, cost less, and even (somehow) be healthier. Nobody will buy the bar you’ve been working on once this one hits the stores.
What do you do? Do you spend the last $100,000? Or do you walk away?
Now, imagine a different scenario. You’re about to start developing a new chocolate bar, but you haven’t spent any money yet. You’ll have to spend $100,000 to get started. Then you get the same news as last time—your competitor is going to release a bar that makes your chocolate worthless. Do you start work on a new chocolate bar anyway? Or do you walk away?
In the 1980s, some researchers posed a question like this to a bunch of people. In the first scenario, almost everyone said they would invest the $100,000, and in the second scenario, people said they would not invest the $100,000.
This is weird, because the outcome is exactly the same. In both cases, you’ve been asked to invest $100,000 in a chocolate bar that nobody wants to buy, so in both cases, your answer should be “thanks, but no thanks”.
What is going on here?
This is the sunk cost fallacy. It’s people’s tendency to make decisions based on how much money (or time, or other resources) they’ve already spent, rather than thinking about whether the money is worth spending on its own. Here are some examples you might be able to relate to:
- Paying for constant repairs on your car, because you want to make previous repairs “worth it”
- Buying something at a shop, even though you didn’t see anything you liked, because you’d gone all the way out there and you needed to make the trip worthwhile
- Staying in a job you hate because you’ve been there for ages, and you don’t want to lose your seniority by starting out somewhere else
The reason this isn’t great is right there in the name—the cost is sunk. The money’s gone, and it’s never coming back. Start the grieving process.
Think back to that chocolate bar from the first example. In both scenarios, you had the option of spending $100,000 on something that wasn’t going to work. It doesn’t actually matter how much you’ve already spent—either way, it’s $100,000 down the drain. The million dollars in the first scenario was the sunk cost.
Why would we do this?
The sunk cost fallacy is connected to another theory—loss aversion. This is the idea that people really hate losing stuff. In fact, they hate losing stuff more than they like getting stuff. So, we tie ourselves in knots in order to convince ourselves that money we’ve spent was “worth it.” That way, we can avoid feeling like we’ve lost money—even if we’re spending more money, just to avoid that feeling.
Back to investing
If you’re not careful, the sunk cost fallacy can get you when shares go up in value! Say you buy some shares, with the intention of selling them in a year. They go up by around 10% in a month, so you sell—this way, your initial investment (a.k.a. your sunk cost) was “worth it”. But what if the shares go up even further over the next 11 months? You’ve missed out on all those gains, because you were afraid of losing your sunk cost.
When you’re investing, you can avoid the sunk cost fallacy by:
- Setting a time frame and sticking to it
- Buying regularly, so you get bargains when shares go down in price (this is called dollar-cost averaging)
- Only investing an affordable amount
It may take nerves of steel, but avoiding the sunk cost fallacy is a great way to make better decisions—not just in investing, but in your everyday spending and life in general.
Have you ever gotten stung by the sunk cost fallacy?