Why we can't stop throwing good money after bad
Don't throw good money after bad money. It's an idiom we've all heard before, but what does it mean?
It can apply to a lot of things. One of them is the sunk cost fallacy: the tendency to stay the course simply to justify a previous investment (of time, money or effort), even if changing tack will lead to a better outcome.
To truly understand the fallacy, you need to first understand 'sunk costs'.
"Costs that cannot be avoided or recouped, whatever choice is made, are called 'sunk costs'," says John Quiggin from University of Queensland.
They can lead us astray in two different ways.
"On the one hand, we may think that, having invested heavily in a project, we should see it through, regardless of future costs and benefits, rather than waste all our effort."
"On the other hand, we may conclude that, no matter what happens in the future, the project as a whole is bound to have had more costs than benefits and that we should therefore abandon it immediately."
Both forms of reasoning corrupt decision-making.
"What matters to a choice are the alternatives available now, not the costs that have been incurred in the past."
"Sunk costs should not influence our decisions, since there is nothing we can do to change them."
Falling victim to the sunk cost fallacy is human nature. Research by Daniel Kahneman and Amos Tversky famously demonstrates that humans are suckers for loss aversion - we get more pain from losses than pleasure from gains.
Being aware of the sunk cost fallacy can help you make clear-eyed investment and personal finance decisions.
On the investment level, question companies that keep flogging a dead horse.
"You could have a company that pursues a project that may not be successful because of the amount of money it has already invested in it," says Lionel Page from University of Technology Sydney.
Page points to the example of the Concorde.
"Soon after it was created, it wasn't attracting enough passengers. The British and French governments had the option of ceasing production or continuing in the hope it would make up the money invested initially."
Rather than cut and run, the British and French governments continued funding the plane despite there being no economic case for it. Such is the notoriety of this example that it's sometimes referred to as the "Concorde fallacy".
"If you want to maximise profit, the only thing you should consider is the prospect of making money in the future without drawing attention to how much has been lost or invested."
Staying on the airline analogy, Airbus cancelling its A380 program after just 13 years of production and a $25 billion investment is an example of successfully avoiding the sunk cost fallacy. The airline industry no longer had appetite for this type of aircraft, so the investment lost was written off because it had no positive affect on future earnings.
"Everyone said 'it's a pity they're cancelling it after all they've invested,' but the managers were aware of the sunk cost fallacy where they said 'we may be able to recoup the investment, but at the moment the best thing is to let it go'.
"Cancelling the A380 was bold because it violates our intuition about the sunk cost fallacy, but it's the right thing to do."
Cutting losses are especially bold for public companies beholden to their shareholders, especially when the failed endeavor has been funded through the sale of shares.
"You have to accept failure rather than pretending it's not a failure and pushing the can down the road."
The fallacy invades our management of personal finance too.
An Ohio University study by Hal Arkes and Catherine Blumer examined the following hypothetical:
Assume that you have spent $100 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?
Avoiding the sunk cost fallacy would put you on the Wisconsin ski trip. Yet in this study, 54% of people chose to hit the slopes in Michigan.
It's all well and good to understand the theory behind all this, but we humans are fallible creatures. Tactics should be employed.
"There are ways people can avoid sunk cost fallacy," says Advice Intelligence CEO Jacqui Henderson.
Henderson employs a goal-setting strategy with her clients.
"The primary focus of goals-based investing is to maximise a client's chances of achieving their specific goals, whatever they happen to be."
"For every goal there are clear metrics; the time horizon between your current age and your desired retirement age, there is a lump sum or an ongoing retirement income target. These are the "outcomes" you are wanting to achieve for this investment, and this is where you should always start - with your goal."
There is also a flip-side to the sunk cost coin. Being overly aware of the sunk cost fallacy may equally lead to ditching things prematurely.
Say you've flunked your first semester of a university degree. The sunk cost fallacy suggests that you should pull stumps and go home. But with effort and commitment, it's possible to right the ship and make a success of it.
"It's important to recognise when something has potential and give some weight to this intuition, rather than flippantly stopping something," says Page.
At the end of the day, avoiding the sunk cost fallacy is an exercise in harm minimisation. Don't be shackled by the past. Rise above, accept failure and move on. Doing so will give you the best chance of future success.