The Sunk Cost Fallacy

How To Know If You Are A Victim Of The Sunk Cost Fallacy

The sunk cost fallacy is one of the most dangerous logical fallacies you can fall victim to.  As soon as you start to feel as though you have invested time or resources into an activity, you are likely to want to continue investing in that activity.

What makes this even more difficult is that fact that you can always find someone who would tell you to keep pushing on or keeping going down the same road.  Nearly everyone has been exposed to some type of motivational meme or quote that leads you to believe that quitting is never an option.

Far from the truth, successful people in all walks of life are ones who know when to push on and when to fold.  There is no use in banging your head against the wall when something is not working.

 

Three Feet From Gold

 

As most of us know, whether it is a relationship, business or investment it’s hard to let go of something you have put so much into.  This is where discerning between a sunken coast and a situation where you need to keep pushing becomes an art.

After all, nearly everyone who has read any type of self help literature has heard some purmutation of Napoleon Hill’s three feet from gold story.  The story begins with the following opening remarks:

“One of the most common causes of failure is the habit of quitting when one is overtaken by temporary defeat. Every person is guilty of this mistake at one time or another.” – Napoleon Hill

The author then goes on to tell the tale of a gold miner who bought a lot of gold and began mining it.  After he was unsuccessful for a period of time he gave up and sold the lot to another prospector.

Once on the lot the new prospector quickly struck the gold that the original miner could have hit.  The idea is that many people miss success by holding out just a little longer to see what they can get from a situation.

The problem with this type of story is it gives people a false expectation that by holding on, they somehow have a better chance of success.  The reality is that time and effort invested guarantees nothing.  If your odds do not seem any better then when you started, they probably are not.

While the idea of being “three feet from gold” is a good mental model to use for activities that show promise or have a reasonable guarantee of success, it is poorly suited to activities where the outcome is truly unknown and there is no way to get any feedback about your progress.

A great example of the proper application of the idea of being “three feet from gold” comes from Scott Adam’s self help styled book How To Fail At Everything and Still Win Big.

In the book, Adams discusses how he woke up every day telling himself that today was the day he was going to make it.  On the surface this seems like a pretty crazy idea.  If you look at the context of his attitude and beliefs it all makes sense.

Instead of using the idea that he was “three feet from gold” to ignore the feedback he was getting from the world, he used it to find new approaches to the main problem he was trying to solve……how to be a successful entrepreneur?

Adams says that he viewed himself as a serial entrepreneur.  Even when he was working for a big corporation he viewed himself as an entrepreneur.  By waking up every day and feeling that that was the day he was going to make it he was able to provide himself with the energy he needed to run the many experiments he ran on the many different business ideas he tried.

Adams was hardly ever doing the same thing and expecting a different outcome.  He was staying motivated and repeatedly trying while changing his approach.  He also had a reasonable guarantee of success as he was fairly certain he was a reasonably smart guy with a fair bit of business knowledge.  Adams knew that if he kept plugging away with one idea after the other and not quitting until they clearly were not working, sooner or later one of the ideas would hit.

 

When You Are Not Three Feet From Gold

According to David McRaney of You Are Not So Smart the main problem with the sun coast fallacy is that it involves self delusion.  David Writes:

“The Misconception: You make rational decisions based on the future value of objects, investments and experiences.”

“The Truth: Your decisions are tainted by the emotional investments you accumulate, and the more you invest in something the harder it becomes to abandon it.”

   Given the above it becomes a little easier to determine when you might be a victim of the sunk cost fallacy.  Any time your decision making process involves thinking about past events you are setting yourself up for making an emotional decision.

While it’s still important to consider the past, when it comes to making a decision you only need to think about what the result of that decision is going to be in the future.

This point is so important I am going to say it again.  You should only consider the effects your decision will have going forward.  If you are thinking about how your decision will look in relation to your past or decisions you made in the past you are falling victim to the sunk cost fallacy.

Don’t beat yourself up over it though, it is extremely common.  In fact, the most widely used study that proved this fallacy was one involving a set of tickets purchased for two separate ski trips.

For this study, researchers asked people to consider what their outcomes would be if they had purchased tickets to a two separate ski trips.  The first trip they purchased tickets to was more expensive then the second trip.  They then purchased tickets to a second trip that was more desirable then the first on but cheaper.

Finally, the subject were told that the trips were to take place during the same time and that they would have to choose between one or the other.  Without exception, the subjects chose the trip that was more expensive even though it was less desirable.

Keep in mind that both sets of tickets were paid for.  Regardless of which trip they ended up going with they would be paying for both.  Still, the thought of “wasting” the more expensive tickets kept the subjects from going on the more desirable but cheaper trip.

While this seems pretty ridiculous when explained in a straight forward manner like that it happens all the time in our everyday lives.  I will give a couple examples of the sunk cost fallacy’s most common occurrences below.

At Work or In A Business Venture:

Jobs and business ventures are probably second only to relationships when it comes to the sunk cost fallacy.  The reason for this is that both jobs and businesses give you a sense that your dedication is enough to secure the growth of your investment.

In this case your investment is the time you put into a job or career to move up the ladder.  Whether you work at a fortune 500 company or a startup, employees are usually incentivised to stay.  The form of the incentive is usually a more prestigious title, better pay or stock options or equity.

A common system of incentives for startups and major corporations is to offer a large package of equity or stock options that can only be realized after working for a period of time in the company.  A very common period of time is three years.  In this case you might actually have an incentive to stay at the company>  Regardless, the same rules still apply to your decision making process.

The question you need to ask is how will this decision impact the future.  Will my outcome be better or worse based on deciding one way or the other.  The most common disruption to a clear mind when making work related decisions is thining that some potential future scenario will remedy an undesirable scenario you faced in the past.

For example, say you have spent the past 24 months working 80 hours per week at an investment back in order to move from an analyst to an associate.  Now lets say that 4 months before you are set to move to an associate position someone approaches you about a partner level position at a promising startup with 10% equity.

Obviously there are people who could make arguments to stay with your current job or to take the position as a partner.  The important thing to keep in mind is that the decision should be based on your expected future value of either role.  You should be taking into account things like your expected work hours, take home pay, total compensation with equity or stock options as well as enjoyment on the job.

The one thing you definitely do not want to enter the equation is whether or not you might be able to mitigate past losses of time and enjoyment you experienced working as an analyst by recouping those losses in a better role as an associate.

Its very easy to fall into the trap of thinking that if you do not take the better position you will have worked that hard for nothing>  It’s easy to rationalize that you wont have maximized your time unless you cash in on the effort you put into the analyst job by graduating to the associate job.

The truth however is that what you did in the past does not actually have any affect on the expected future outcome of either result from your decision.  The only thing that matters is a cold rational analysis about what your expected outcome will be.

The only time this is not the case is if you have convinced yourself that that time will have been lost without cashing in on the higher level position and you know it is going to eat away at you for years.  The problem with this realization is that you are openly acknowledging your inability to think rationally and at least try to put your emotions aside.

If you are thinking  about work related decisions in this way then it is time to stop.  In terms of time and money, the only thing that matters is your expected future outcome.

 

Relationships:

Relationships are the most common place for the sunken cost fallacy to cloud your judgement.   One of the reasons it is so hard to spot the sunken cost fallacy in relationship decision making is because the topic is inherently emotional.  People do not like to consider friendships or romance in a cold calculating way.

While I agree that it feels unnatural to consider relationships in this way, it is still a good idea to fact check your feelings once in a while.  It’s at least nice to find out whether or not the story you are telling yourself is at all based in reality.  With relationships the investment and lost opportunity cost of spending your time with other people heavily biases most people’s decision making.

Your decision will be bias by your past investment in a particularly strong way if you felt that your relationship with another person was progressing.  This is what usually happens to couples who set a timeline for when their relationship will progress.  usually these people have a specific timeline they are following for when they should reach different milestones in a relationship such as moving in, getting married, having ids ect….

When the thought of ending a relationship enters a person’s mind they don’t think only about how their future will look given either decision.  They also take into account all the time they invested moving from one milestone to the next with the person they are currently in a relationship with.  This causes them to attach an unreasonably high value to the person they are currently in a relationship with.

This of course does not take into account people’s various beliefs about commitment.  Some people of course value commitment for commitment’s sake, nothing wrong with that.  However, it’s still good to be aware of why you are making a decision and the different factors that are affecting your decision.

The same thing can happen with any types of close relationship.  Often times people will remain friends with those around them simply out of convenience sake.  Even when a person’s beliefs no longer match their own they are willing to keep spending time with them because of all the time they have spent with them in the past.

In the same way that someone will resist leaving a relationship with a significant other, they will resist leaving relationships with friends out of a sense of loss of the prior investment.  This once again prevents them from clearly seeing the difference in value of either relationship going forward.

Play To Win, Don’t Play Not To Lose

One of the most important concepts that anyone who wants to get better at decision making must understand is the concept of expected future value.     Expected future value is the likely value of what the future will hold given your present decision.

One of the best examples of expected future value comes from the game of poker.  When playing various hands it pays to now your expected outcome relative to the amount of money you are betting.

I like this example because the money you are betting is akin to the time money and effort you will put into any major life decision.  Understanding this example allows you apply the same concepts to a wide range of potentially life changing decisions.

“Let’s pretend based on that player/hand example that the player would fold 40% of the time. Let’s pretend you’d lose the hand 100% of the time he calls (you wouldn’t, but again we’re keeping the example simple). Assuming these things, here is what would happen:

60% of the time, you’d lose $15.

40% of the time, you’d win $30.

60% x ($15) = ($9)
40% x $30 = $12
(-$9) + $12 = $3
EV = +$3

Your EV is $3, because that’s your expected profit from making that bet. Whether you lose on this one individual hand is irrelevant. You make $3 in EV. Over the long run, all of the +EV spots add up. A LOT. Most amateurs would pass up that spot to bet. Most professionals would not.”ForeverJobless

This example relates perfectly to many decisions in life that have a relatively high probability of loss.  People will look at the probability of loss and not be able to wrap their head around it.  As mentioned above, humans are much more sensitive to loss.

As soon as we realize their is a potential for loss it is almost as though all further calculations stop.  This is a huge mistake and will end up costing you a ton of time, money and effort in the long run.

As the example above demonstrates, you are literally leaving money on the table by allowing your decision making to be taken over by your loss aversion.  You need to be able to resist your tendency to want to avoid loss by understanding exactly what you stand to lose as well as what you stand to gain in the future given your choice.

Even when you might lose something substantial, when you are just as likely to gain something far more valuable it is in your best interest to go for it.  Over time, playing all your decisions is far more safe.  Given enough time, this strategy nearly guarantees a poor outcome.

Conclusion

It’s definitely easier to write and talk about the suck cost fallacy then to actually prevent against it in your everyday life.  Generally the decisions that are most heavily influenced by the sunk cost fallacy are those that are heavily charged with emotions and confounding factors.

The decisions that are the hardest to make are the ones that are complex and can be approached from many angles.  While it would be nice to look at ending a career or a relationship in the same way you can look at raising a bet in a game of poker, the potential outcomes of decisions involving complex matters are far more nuanced.

 

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