The Sunk Cost Fallacy

Individuals commit the Sunk Cost Fallacy when they continue a behaviour or endevaour as a result of previoulsy invested resources.” (Arkes & Blumer, 1985)

If we’re honest, I suspect that we would all like to think that given a situation and presented with a choice, we would make a rational decision, based on the future value of the endeavour in question.

Consider climbing Mount Everest.

  • Situation: After 6 months of planning, £70,000 investment a 6 weeks of acclimatisation, and 3 weeks of climbing, the summit is only another 2 hours away.   However we must get back down to the High Camp within 3 hours from now, otherwise we’ll be stuck overnight in the Death Zone, which sounds nasty.
  • Rational decision: Go down.  Do not attempt the summit.  If it’s 2 hours up, and 2 hour’s down, we won’t make camp in time, and we’ll be straded in the Death Zone – with no hope of rescue.  It’s suicide.
  • Sunk Cost Fallacy:  I’ve invested so much of my life over the past year to get here, I’ve spent £70,000 and I’m within 2 hours of standing on the top of the world – I’m not going to throw all that away when I’m so close!  I’m continuing up.

It seems such an obvious choice to make when you see it in print, and when you’re not 25,000 feet up the tallest mountain in the world!

But the Sunk Cost Fallacy strikes when the mounting emotional investments that you have made over time begin to taint your decision making ability – because the more you emotionally invest in something, the harder it is to abandon it.

In economics, a sunk cost is a cost that has already been incurred and can not be recovered.  It’s gone.  Spent.  No longer in the equation.  Since it has gone, it should no longer feature in a company’s decision making processes for the future.

In the Everest example, the fact that you’ve spent £70,000 is irrelevant when you are at 25,000 feet deciding on whether to risk your life trying to summit the mountain.   The £70,000 has been spent.  The cost has been incurred, and can not be recovered.   Since it has gone, it should not feature in your decision making processes for the future – which in this case seems quite short.

There are many examples of companies sticking to their guns, when it would have made more sense to rethink their strategy.  Nokia and Kodak are examples:

  • Nokia.  Smartphones appear on the market at a time when Nokia were riding high in the mobile phone market.   Apple launches iPhone with IOS, and Google launches Android OS.   Nokia decides to invest heavily in Symbian – it’s own proprietry mobile OS.  The result is that Nokia suffers hughe financial losses, and sells out its mobile division to Microsoft.   Nokia got caught in the Death Zone.
  • Kodak.  Digital cameras launch in the market, replacing film with removeable memory.   Kodak decides to invest in film, and to market film as the superior product for producing quality images.   The result is that Kodak files for bankruptcy.  Kodak got caught in the Death Zone.

There have been experiments to test the human propensity to cling to our emotional investments, regardless of the current adverse conditions.   In one experiment, a $5 bill was auctioned with the following rules:

  1. The highest bid secures the $5 bill.
  2. The second highest bidder, loses their bid.

The bidding started at 2 cents, with several people placing bids.   Clearly people felt that it was worth trying to purchase the $5 bill for less that its face value.   As the bidding got closer and closer to $5, more and more people dropped out.  Remember, if you are the second highest bidder, you lose your bid.

The bidding continued and increased to beyond $5.  The two bidders left became locked – neither wanted to come second, and lose their bid.  They had invested emotionally.   The winner would now have to spend more than $5 to win the $5 bill, and therefore make a small loss, but the bidder who came second, would lose everything.

Eventually, the bidding broke $10, reaching $10.25. The winner made a loss of $5.25, and the bidder who came second made a loss of $10.00.  The experiment was repeated over and over again with different groups, and in every case, the same thing happened.

The more people invested emotionally, the more they found if difficult to abandon the bidding – regardless of the non-sensical and irrational bids they were making.

Sunk Cost Fallacy can also be found in the world of Change Management.   Consider a project which has been running for some time.   There have been several change requests along the way, asking for more funding because things have changed.  The market, the requirements, the cost, the time required to deliver due to unexpected complexity, etc.

The diligent project manager pulls together a change request, to present to the Change Board.  More funding required…

As I said at the top of this blog, I suspect that we would all like to think that given a situation and presented with a choice, we would make a rational decision, based on the future value of the endeavour in question.

But how many times has a Change Board ended up bidding $10.25 for a $5 bill? Or continuing to invest heavily in film instead of digital?  Or continuing to climb, when the only real rational choice is to cut the losses and head down to camp?

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