KEEP CALM AND MOVE ON
OVERCOMING THE SUNK COST FALLACY
Congratulations! You’re the proud new owner of a boat. It’s a pretty sweet boat too. It’s got all the doodads and gizmos you wanted and you negotiated it down to your budget of $5000. Plus the guy guaranteed it seaworthy for a year or he would buy it back from you for the same price. You’re excited, but winter is nearing so you put it in storage for a $100 a month. You spend the next several months dreaming of all the great times you’re about to have out on the water. Before you know it, springtime comes around and you can literally hear the ocean calling out to you.
You rent a slip for the season at $200 a month and on a perfect Saturday morning, you fill it up with $50 of gas and head to marina. Finally, the day you have been waiting for arrives, when disaster strikes. You get the boat into the marina and the thing starts taking on water. Turns out, the hull has to be repaired and the bilge pump needs to be replaced. The harbormaster says he can fix it, but it’ll take a week and it’s going to cost $1000.
You think back to all those naysayers who warned you about buying a boat. You remember distinctly, the wise words of your know-it-all uncle, “If it flies, floats or fornicates, always rent it”. You remember, because it was uncharacteristically vulgar and he didn’t actually use the word “fornicates”. Curious, you looked it up later to find your uncle was unwittingly paraphrasing the late British publishing tycoon, author and poet, Felix Dennis.
You’re pissed, but you take a beat, collect yourself and on the back of the envelope the boat keys came in you do some quick math. If you return the boat, you get back the $5000, but you’re out the $400 for the winter storage, plus the $200 deposit on the slip that would have rolled over into the first months rent on the slip. Not to mention the the gas, the boat launch fees, license fees and registration fees. And let’s not forget that killer captains hat you just had to get at the flea market. All in, you figure you’ve invested an additional $1000.
Now if you keep the boat and get it fixed, you’ll be out another grand, but the additional $1000 you spent will have not “gone to waste”. You think to yourself, “hell, if I give it back, I basically paid to store the guy’s boat for the winter and returned it with a full tank of gas.” So, you bite the bullet and get the boat fixed. One week later you’re out for a cruise with your friends, confident that you’ve made the right move. But have you?
Nope, you blew it. But don’t fret too much, you’re in good company. We like to think that we analyze information logically and make decisions rationally. But that simply is not the case. In this hypothetical story, you have just fell for one of behavioral economics most insidious of cognitive bias’, the sunk cost fallacy.
Simply put, sunk costs are unrecoverable costs. They are investments of money, time or effort that you cannot get back. The fallacy is that these cost should be accounted for in future decision making. However, If we were “rational economic actors” we would not allow sunk costs to influence our current decision making. Of course we are not purely rational, we are emotional beings and these losses hurt. According to the preeminent psychologists in the field of behavioral economics, Amos Tversky and Daniel Kahneman, you have made this cognitive error in response to an imbalance between losses and gains that exist in the human mind.
Remember that initial $5000 for the boat was recoverable, so it wasn’t a sunk cost. That additional $1000 you spent on everything else was a sunk cost. It’s gone and it should have no bearing on future decisions. You then put in another $1000 to get the the boat to the level of value you expected it to be at the $5000 price. Shame, shame, you made the proverbial mistake of throwing good money after bad.
You have essentially decided the boat has a value of about $6000. However, the boat actually has a net value of about $4000 as you would need to spend an additional $1000 to get it to the $5000 market value. You have let your aversion to loss, affect your decision making. If you would have made the decision to return the boat, you could have bought a similar one for $5000. You probably would have made sure it floats before buying it and ultimately you would have saved yourself about $1000.
In his book, “Thinking Fast and Slow”, Kahneman claims that, “When directly compared or weighted against each other, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.” This is a great example of how nature is often effective, but not always efficient.
It’s the old idiom, “waste not, want not”. We all have received an oversized portion of food and stuffed ourselves beyond comfort. Why? Because our instinct is to not let the food go to waste. But if we don’t really need it or even want it, are we really wasting it? It’s probably better that we save ourselves the discomfort and let those calories go to waste.
Loss bothers the hell out of us. It hurts most in the beginning and the effects take time to fade. Imagine you go to see a movie. The ticket will cost you $10. When you go to pay for your ticket you realize that $10 is missing from your wallet. You’re bummed, but you have more money, so you suck it up and buy the ticket. Now, imagine you enter the theater having not just lost $10. You buy your ticket without hesitation, but when you get to the ticket tearer, you realize that you’ve lost it. Would you go back and fork up another $10?
Through experimentation, Kahneman and Tversky discovered that you probably wouldn’t. The found that only 12% of participants said they wouldn’t pay for a ticket after realizing they had just lost $10, while 54% of subjects said they wouldn’t repurchase a ticket upon its loss.
In both scenarios, the subjects have lost $10 of value. However, because of the sunk cost fallacy we tend to assign the loss of the ticket more directly to the overall value of the experience. We are now asking ourselves, is this experience worth $20? Because we know the market value of the experience is $10, we often decide it’s not worth it. But would you carry that loss to the next movie you went to, say 2 months later? Of course not. How do we overcome this instinct, unburden ourselves from our sunk costs and move on?
RE-FRAMING
Now that we have a better understanding of how sunk costs influence our decision making, let’s consider a way to overcome the fallacy. Whether it’s a project that has gone over budget or an investment gone awry, you need to make the decision — Do you carry on or move on?
You’ve gotten over the first hurdle — You are aware of the sunk cost fallacy. Now, in order to emotionally detach yourself from the sunk costs, you need to re-frame those cost for your decision making. Steve Rawling, journalist and author of the book, “Be Creative — Now!”, has created a tool to help us do just that. Rawling suggests to, “Use this technique when things are going wrong and you need to decide whether to pull the plug or carry on” … “This technique — thanks to a bit of origami — literally puts past losses out of sight while you think about the future, and then for good measure, reframes those losses as lessons learned.” — See video below for a Rawling’s description of how the tool works.
Imagine that upon the discovery of the issues with your boat, you were to view your sunk cost not as a wasted investment, but the cost of lessons learned. Lessons like, never buy a boat until you see it float! Maybe get it inspected by a professional next time. You might want to avoid hearing, “I told you so” from your arrogant uncle, but maybe you consider renting in the future. You may think that you have paid a high cost for these lessons, but they are of value nonetheless. By applying this cost to the lessons learned you are able to make your next decision not only unencumbered by your sunk cost, but more knowledgeable because of them.
FINAL NOTE: THE SUNK COST RE-FRAMING CANVAS
While very useful, I found Rawling’s re-framing tool a bit too specific to project management for broad sunk cost fallacy use. Also, because Rawlings calls the UK home, his printable PDFs are in the A4 format, which is a bit hard to come by here in the States. As such, I have created a slightly adjusted canvas in the US letter format. You can find the download link here — The Sunk Cost Re-framing Canvas — Enjoy!
