One mistake you make all the time, and how to stop

Money Down The DrainThat stock was a sure thing! Now that’s it down 40%, you’re still holding onto it; thinking that you need to make your money back before getting out. Feeling down about your trading losses, you remember that you have tickets to the ballet that same night. You really just want to stay home, but since the tickets are nonrefundable, you force yourself to go and have a miserable time.

These are two example of the Sunk Cost Fallacy, a common reasoning mistake that almost everyone makes, and that can cost people a lot more than a bad theater experience.

To act rationally, we need to ignore costs that we’ve already paid, and make decisions based solely on future prospects. Unfortunately, it’s very hard for people to act this way – it’s just not the way we’re wired.

At Cartwheel, we see the Sunk Cost Fallacy in action all the time. For example, we meet a new client that recently bought a server that isn’t meeting his needs. After learning about his workflow, we find the business would run best if all his documents were moved to the cloud. Unfortunately, this costs money, and since the client already spent money on the server, he decides to continue using it – to the detriment of his business.

In this example, the rational thing to do is forget the sunk cost of the server, and evaluate the new solution based on a future cost/benefit analysis. But despite ourselves, many of us tend to assign value to sunk costs.

So how do we overcome this irrational bias? Unfortunately, it’s very difficult. Economists suggest making a hard-headed cost/benefit analysis, ignoring the sunk cost. But in many of the decisions we face, it’s hard to put a dollar amount on perceived benefits.  Psychologists suggest we separate the sunk cost from other factors that may be affecting our decision, for instance emotions like regret – another difficult task.

One thing that works for us is to seek advice from an unbiased friend, advisor, or accountant. Since the sunk cost isn’t theirs, they won’t be affected by it, and should be able to process the future cost/benefit better. So next time you find yourself saying things like “I really should X, but I already did Y”, stop, and call a friend.