Sunk cost fallacy: Throwing good money after bad

It's why we deny ourselves fun, keep poorly performing

employees, and up the ante when investments go south

In research for my next book, Big Decisions: Why we make them badly, how we can make
them better, I have identified more than 300 mental traps, errors, fallacies and other factors
that can lead to bad decision making. You can learn more about my book at Make Big
Decisions Better.

To build on the insights in my recent post, 10 surprising mental traps: Why we make bad
decisions, this post begins a series exploring more of the many reasons we make bad
decisions.

Definition

Sunk cost fallacy (also called the "sunk cost effect," "sunk cost heuristic," "Concorde fallacy,"
"argument from waste," "investment trap," "escalation of commitment," "irrational escalation"
and "escalation bias.")
In economics, a sunk cost is any cost that has already been paid and cannot be recovered.
The sunk cost fallacy is a mistake in reasoning in which the sunk costs of an activity - instead
of the future costs and benefits - are considered when deciding whether to continue the
activity. The sunk cost fallacy makes it more likely that a person or an organization continues
with an activity in which they have already invested money, time, or effort, even if they would
not start the activity had they not already invested in it. The greater the size of the sunk
investment, the more people tend to invest further, even when the return on added investment
appears not to be worthwhile.

This trap is sometimes described as "throwing good money after bad," because the resources
and effort are already lost, no matter what you do now.

How it works

Research shows that sunk costs worm their way into decision making because the previous
act of investing raises people's confidence that they have made a good bet that will pay off,
whether or not this is truly the case.1 Other research shows that people who feel personally
responsible for creating sunk costs are more likely to subsequently "up the ante" because of
the previous costs.2

According to researchers Daniel Kahneman and Amos Tversky, a reason people fall prey to
the sunk cost fallacy is loss aversion: People tend to have a much stronger preference for
avoiding losses than for acquiring gains.3 Continuing an activity based on sunk costs enables
us to avoid (at least for the short run) what social psychologist Dan Ariely calls "the pain of
paying."4

Psychologists cite "cognitive dissonance," "plausible deniability" and "regret avoidance" as

reasons for the sunk cost fallacy: Continuing one's past behaviour, in this case extending and
enlarging a prior commitment that otherwise does not make economic sense, is seen as
justifying our past behaviour, maintaining the appearance that we did not make a mistake, and
avoiding the regret that we would experience by stopping the activity in which the investment
was made.5

Why it's a problem

Sunk costs are "irrelevant data" from an economic viewpoint because they are independent
of any possible future event: Continuing an activity only because of prior investment is thus
seen as irrational behaviour unlikely to result in the best outcome.6

Author David McRaney describes the sunk cost fallacy as continuing "a wasteful loop of
behaviour because of your fear of loss."7 Waste of resources matters in business, public affairs
and economics.

Thinking that greater investment in something you have already invested in will "make it work"
not only can be the result of the sunk cost fallacy, but the further investment magnifies the
commitment to the activity and can increase the possibility of yet more investment based on
sunk costs.

Perhaps even worse, escalation of commitment to a course of action only because of past
investment can block needed change and limit innovation.

Examples

Which ski trip?

Which would you choose: paying a high price or having more fun?

Research by Ohio University psychologist Hal Arkes and partner Catherine Blumer suggests
that sunk costs may dissuade you from choosing "fun" when it is an option. They asked 61
college students to assume that, by mistake, they had purchased tickets for a $50 ski trip to
Wisconsin and a $100 ski trip to Michigan - for the same weekend.8 The students were told
they would have much more fun on the $50 trip to Wisconsin than the $100 trip to Michigan.
Then they were asked to choose one of the trips and let the ticket for the other trip go to waste.

Surprisingly (unless you anticipated the sunk cost fallacy), a majority of students (33 of 61)
chose the less enjoyable $100 trip. It seems the higher sunk cost represented by the $100
payment was more important to them than getting greater enjoyment from the less expensive
$50 trip that they had paid for, as well.

Aircraft waste, first case.

Why would two countries waste huge sums of money over four decades to develop an airplane
that no one would buy except their own national airlines who were heavily subsidized to do
so?

Consider the case of the Concorde, the first supersonic (SST) commercial airliner. The
Concorde was built in a 42-year program by a consortium of British and French companies
backed by their governments.

Concorde development began in 1962 based on a treaty between the two countries. The plane
began commercial service in 1976 and flew for 27 years. The costs to develop the Concorde
were £1.134 billion, which was funded by the UK and French governments. The cost to build
the small number of Concordes produced for commercial service, 16, was £654 million, of
which only £278 million was recovered through sales. This debt was also funded by the two
governments.9

Consultant Peter Saxton, a former RAF pilot and British Airways Captain, chief pilot and senior
manager, says the Concorde was "a project which cost the British and French tax-payers a
staggering amount for development and construction, was not well managed if massive cost
overruns are anything to go by, never made anything close to a financial return for its investors
(us), and led the British aircraft industry into a cul-de-sac."10 He calls it a "a stupendous
example of a project that was kept alive for a whole raft of reasons, none of which seems to
have included the serious intention of making a commercial return for investors. Those
reasons...included maintaining technological expertise, providing employment, securing
Britain’s entry into the European Common Market, and patriotism or prestige." Saxton
surmises that the governments kept "throwing more good money after bad" because they
"seemed prepared to pay the prestige premium no matter how high it rose."

It was this "escalation of commitment" that gave the sunk cost fallacy a new name: the
Concorde effect.

Aircraft waste, second case.

The second aircraft example of the sunk cost fallacy is current. Immense and rapidly growing
sunk costs are at least partly why U.S. defense contractor Lockheed Martin expects production
of its advanced F-35 Joint Strike Fighter to increase 10-fold by 2018.11

The F-35 program has been plagued by delays and cost overruns over its 14-year history. At
nearly $1.5 trillion in expected lifetime costs, the F-35, under development since 2001, is the
Pentagon's most expensive weapons program ever. To date, while production of 2,400 plus
F-35s is planned, so far the Pentagon has only purchased about 220 planes. Yet the Pentagon
has continued to escalate its investment in the F-35: Expected program costs have increased
43% from 2001.

Last year's Government Accountability Office report on the F-35 program stated, according to
Government Executive, "Currently the acquisition program requires $12.6 billion per year
through 2037.” It said the Defense Department will need to increase program funding steeply
over the next five years. Alarmingly, it concluded, "Additionally, the most recent cost estimate
for operating and supporting the F-35 fleet is more than $1 trillion, which [Pentagon] officials
have deemed unaffordable.”12

The program continues to be funded.

My employee performs better than yours.

Think twice before giving an employee you hired a glowing performance appraisal. Your
appraisal may be influenced by the sunk cost effect.

That's the takeaway from a study by Purdue University psychologist David Schoorman that
uncovered "escalation of commitment" in performance appraisals of clerical employees in a
large public sector organization.13

Supervisors evaluated three groups of employees: (1) those whom they were not involved in
hiring; (2) those whom they were involved in hiring and agreed with the hiring decision; and
(3) those whom they were involved in hiring but did not agree with the hiring decision.

Evaluations of employee performance were demonstrably affected by whether the supervisor

had hired the employee and whether they agreed with the hiring decision. Performance ratings
were highest, demonstrating a "positive escalation bias," from supervisors who took part in
and agreed with the hiring decision. Ratings were lowest, demonstrating a minor "negative
escalation bias," from supervisors who disagreed with the hiring decision.

I can't let go of my baby!

Entrepreneurs are ripe for "escalation of commitment," as evidenced by their willingness to
keep investing in their business even if it is performing poorly.

That's the conclusion of a three-year study of 826 new firms with less than 30 employees
conducted by Anne McCarthy of Indiana University and David Schoorman and Arnold Cooper
of Purdue University.14 The owners of these firms had either started the business from scratch
or purchased an existing business.

"The results...show that the entrepreneur who starts a business, and expresses
overconfidence about its chance for success will exhibit an escalation bias in subsequent
decisions regarding the expansion of the asset base of the business," according to the
researchers. The results showed that when entrepreneurs are faced with negative feedback
regarding sales growth in the first year, this tendency to escalate investment is greater. Even
stronger evidence for escalation of commitment is the finding that the "entrepreneurs who
started a business and received negative financial feedback in the second year expressed
significantly higher levels of overconfidence in year three than did entrepreneurs who
purchased a business and received negative financial feedback."

The researchers concluded: "These findings provide support for the view that escalation bias
is a significant and common problem in decision-making among entrepreneurs. The
characteristics of entrepreneurs and the nature of the decisions they are required to make
leave them particularly vulnerable to escalation bias."

No bad loans here.

The sunk cost fallacy is at work in banking. That's the finding of a statistical analysis of bank
lending by Barry Staw of the University of California Berkeley and others who studied the
relationship among bank executives, loss provisions for non-performing loans and actual bad
loans at 132 California banks over a nine-year period.15

The analysis showed that bankers most closely associated with decisions to fund problem
loans were less likely to acknowledge the subsequent risks posed by these loans and the
likelihood of their default. On the other hand, when there was bank executive turnover, the
banks increased provision for loan losses and wrote off more bad loans.

The researchers' hypothesis was that removing the bankers responsible for making the loans
limited the sunk cost effect by reducing "a psychological source of commitment because those
people who have reason to defend or justify a course of action would no longer be present to
promote such a position."

Contrary views

The late Harvard philosopher Robert Nozick suggested that our tendency to honour sunk costs
may be a helpful behaviour when it enables us to overcome the temptation to abandon a
challenging project the ultimate success of which may in fact contribute to our long-run well-
being.16

Based on analysis and several studies, researchers from CalTech, Emory University and
University of North Dakota conclude that acting based on sunk costs is not always irrational.17
They propose that people might rationally continue to invest based on sunk costs because:
  "...greater past investments often indicate that success is closer at hand, and often
reduce the ability or willingness to undertake alternative investments given the
presence of financial and time constraints."
 High risks, as evidenced by high loses, also often indicate the promise of high returns,
or as they write, of "high option values of continuing to invest."
 "...to avoid immediately losing their reputation for smart investment choices."
 "...to create a reputation for commitment," thereby "encouraging others to choose them
as partners, and their partners to invest more."

References

1. Kelly, T., & Milkman, K. (2013). "Escalation of commitment." In E. Kessler (Ed.), Encyclopedia of management theory. (pp.
257-260). Thousand Oaks, CA: SAGE Publications, Inc. doi: http://dx.doi.org/10.4135/9781452276090.n78
2. Staw, Barry; Blumer, Catherine (1976). "Knee Deep in the Big Muddy." Organizational Behavior and Human Decision
Process 35: 124–140. doi:10.1016/0749-5978(85)90049-4. http://citeseerx.ist.psu.edu/viewdoc/download?
doi=10.1.1.470.3668&rep=rep1&type=pdf
3. Tversky, Amos; Kahneman, Daniel (1986). "Rational Choice and the Framing of Decisions." The Journal of Business 59 (S4):
S251. doi:10.1086/296365.
4. Dan Airely. "The Pain of Paying." Blog. February 5, 2013. http://danariely.com/2013/02/05/the-pain-of-paying/
5. Brian C. Gunia, Niro Sivanathan, Adam D. Galinsky. "Vicarious entrapment: Your sunk costs, my escalation of commitment."
Journal of Experimental Social Psychology, Volume 45, Issue 6, November 2009, Pages 1238-1244. ISSN 0022-1031.
https://briangunia.files.wordpress.com/2011/10/gunia-sivanathan-
galinsky-2009.pdf
6. http://dictionary.cambridge.org/us/dictionary/business-english/
sunk-cost-fallacy
7. David McRaney. "The Sunk Cost Fallacy." You Are Not So Smart: A Celebration of Self Delusion, March 25, 2011.
http://youarenotsosmart.com/2011/03/25/the-sunk-cost-fallacy/
8. Arkes, Hal and Blumer, Catherine (1985). "The psychology of sunk cost." Organizational Behavior and Human Decision
Processes, 35, issue 1, p. 124-140. http://www.communicationcache.com/uploads/1/0/8/8/
10887248/the_psychology_of_sunk_cost.pdf
9. http://www.concordesst.com/faq.htm
10. Peter Saxton. "Prestige and sunk costs – lessons from Concorde." Capstick Saxton Associates, 12 July 2010.
http://www.capsticksaxton.com/index.php?
option=com_content&view=article&id=133:
prestige-and-sunk-costs-lessons-from-concorde&
catid=40:latest&Itemid=120
11. http://en.wikipedia.org/wiki/Lockheed_Martin_F-35_Lightning_II
12. Charles S. Clark. "GAO Questions Affordability of F-35 Joint Strike Fighter." Government Executive, March 24, 2014.
http://www.govexec.com/defense/2014/03/gao-questions-
affordability-f-35-joint-strike-fighter/81130/
13. Schoorman, F. David. "Escalation bias in performance appraisals: An unintended consequence of supervisor participation in
hiring decisions." Journal of Applied Psychology, Vol 73(1), Feb 1988, 58-62. http://dx.doi.org/10.1037/0021-9010.73.1.58
14. McCarthy, A. M., Schoorman, F. D. & Cooper, A. C. (1993). "Reinvestment Decisions by Entrepreneurs: Rational Decision
Making or Escalation of Commitment?" Journal of Business Venturing, vol. 8 (1), 9-24.
https://www.gwern.net/docs/sunkcosts/1993-mccarthy.pdf
15. Staw, Barry M.; Barsade, Sigal G.; Koput, Kenneth W. "Escalation at the credit window: A longitudinal study of bank
executives' recognition and write-off of problem loans." Journal of Applied Psychology, Vol 82(1), Feb 1997, 130-142.
http://haas.berkeley.edu/faculty/papers/stawbarsade.pdf
16. Nozick, Robert (1993). The Nature of Rationality. (Princeton: Princeton University Press).
17. R. Preston McAfee, Hugo M. Mialon, and Sue H. Mialon. "Do Sunk Costs Matter?" April 7, 2007
http://vita.mcafee.cc/PDF/SunkCostFolly.pdf

© 2015 Lee Crumbaugh. All images are in the public domain.

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