Sunk cost

One day, I sat with my startup’s financial advisor Sarah and we talked about people’s irrationality in making decisions. I always have this thought about humans tend to decide based on something’s that no longer recoverable. Sarah said, “in economics, that’s called sunk cost”. That made me so fascinated in knowing more.

Before I continue banally with defining what sunk cost really is, let me illustrate the phenomenon with an experiment conducted decades ago.

In 1985, Hal Arkes and Catehrine Blumer asked 61 people this question;

Assume that you have spent $100 on a ticket for a weekend ski trip to Michigan. Several weeks later you buy a $50 ticket for a weekend ski trip to Wisconsin. You think you will enjoy the Wisconsin ski trip more than the Michigan ski trip.

As you are putting your just-purchased Wisconsin ski trip ticket in your wallet, you notice that the Michigan ski trip and the Wisconsin ski trip are for the same weekend!

It’s too late to sell either ticket, and you cannot return either one. You must use one ticket and not the other. Which ski trip will you go on?

We would think that since that they will enjoy the Wisconsin trip more, just choose that one. Actually though, more than half of the subjects chose to go with the Michigan ski trip, the one that they would enjoy less.

Why? Because they paid more for that. And that is the sunk cost fallacy in effect.

The prime reasoning of us succumbing to sunk costs is loss aversion. We tend to prefer avoiding losses to acquiring equivalent gains. For instance, we might prefer to not lose RM50 than to find RM50. A study by Amos Tversky and Daniel Kahneman even suggests that losses are twice as powerful psychologically, as gains.

It’s the same reason why we see it’s hard for some people to leave their lovers who are totally toxic — because they have spent a lot of time and energy, emotionally and physically to that toxic lover. Leaving the relationship scares the shit out of them because that means all those efforts and emotional investment will be gone.

The thing is, it’s already gone. And the definition of sunk cost will help in explaining why.

In economics, a sunk cost is a cost that has already been incurred and cannot be recovered. The key phrase here, is it cannot be recovered.

Let’s go back to the ski trip experiment. Assuming you’re one of my Malaysian friends, let’s localised this experiment.

You bought an AirAsia flight ticket to Jakarta for your holiday. That costs you RM300. Excited to change your Instagram bio to ‘#wanderlust’, you also bought a ticket to Bangkok for RM150 because it was on sale. You prefer Bangkok because you prefer the food, the nightlife, and the lack of macet in Thailand.

Being a #careless person, the tickets you bought are actually during the same weekend. You can neither refund your tickets nor change the dates because, you know, AirAsia. You can only go to one of the trips.

Based on the ski trip experiment, more than half of us will choose the Jakarta trip. Because we paid RM300 for that. Based on the loss aversion theory, the majority of us will choose the Jakarta trip because the loss (paying RM300 instead of RM150) is greater than the gain (enjoying Bangkok instead of Jakarta).

In my previous post, I did mention the reason why we need to identify our psychological weaknesses is so that we can do something about it.

In this case, we need to remind ourselves that the lost is no longer recoverable. We already paid RM450 for both tickets. If we go to Jakarta, we still would’ve lost RM450. If we go to Bangkok, we still would’ve lost the same amount.

What’s important is we need to choose the option that will benefit us more in the future. We might already spend 5 years with a toxic person. But the 5 years are already lost. You can no longer recover it. What’s important is the rest of your remaining life.

We might already spend thousands of dollars outsourcing tasks in our company to a lousy third party. But that sunk cost shouldn’t be a reason to keep outsourcing tasks to them. Move on. The cost can no longer be recovered.

I understand past experience should be part of the factor in deciding what to do in the future. But the lost in the past shouldn’t surpass the future gain in value.

I understand this illogical thinking is partly what makes us human. But humans in essence is filled with flaws. Fixing those flaws substantiate the journey of our lives.

Moving on is not being like a robot. It’s the constant part of our lives.

“Life is like riding a bicycle. To keep your balance, you must keep moving.” — Albert Einstein