Making Better Decisions
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You start reading a new book. You get 100 pages into it, when you realize, that it isn’t really your type of book. What do you do?
You go to the cinema with your friends. 40 minutes into the movie, you realize that you will not enjoy the rest. What do you do?
You are on a date. Halfway through it you find out.. that this person isn’t right for you. What do you do?
This is for the people who consider these scenarios and their truthful answer is, that they will finish the book, or watch the entire movie, or wait until the date is over to never call that person again.
If you’ve never done something like that and you think you never will, then you can stop reading right now. Otherwise, we boldly continue on.
The idea I want to explore comes straight from economics and finance. Those disciplines are obsessed with the study of how to make rational decisions that maximize one’s value, or benefit. Therefore, it would behoof us to listen up, when they are in agreement. Such is the case with the principle of sunk cost.
A sunk cost is a cost that has already been incurred and can’t be recovered. The theory says that a sunk cost shouldn’t be considered when making a rational decision, because such costs are in the past. A decision should only be based on the merits and costs it brings from the current point onward.
A resource in this case is most often money, but it can also be one’s time, or energy, or anything else that is of value to that person. Understanding the principle of sunk cost can be the most important thing you may ever do - it can free you to do what you need to, without being influenced by what came before.
Sunk Cost Fallacy
The sunk cost fallacy is when a decision making process is based on, or includes, sunk costs.
Imagine you’re running a marketing campaign for 10 million dollars. 5 million dollars in, you find out that your strategy is not very effective, and is getting very little traction. Would you continue putting money in that form of marketing, or would you use the other 5 million in an entirely new, but much more effective strategy? Most of us would have no problem answering a question like that, however the more involved we get, and the more we become part of the story, the less likely we are to make the correct decision.
The more involved we are, the more likely it becomes that we will fall pray to the sunk cost fallacy.
Why we fall pray to the Sunk Cost Fallacy
The reason we so often fall pray to the sunk cost fallacy has a lot to do with our own hubris. We don’t want to either admit that we’ve made the wrong decision in the first place, or we want to avoid any losses that we’ve already incurred.
This is the same reason that keeps a gambler glued to his seat when he is losing - in his mind the losses are not realized until he stops playing. Therefore, even if he is using a bad strategy, it won’t occur to him to stop and reconsider, because he wants to first recoup what he has already lost. Getting up from the table would be an admission of his bad decisions, and that is something he’d really like to avoid. In that frantic state, a gambler forgets a fundamental rule that we are all privy to, when we are calm and composed - ‘That you shouldn’t go throwing good money after bad’.
Imagine that you buy a movie ticket. As the movie time approaches, however, you find out that all of your friends have gone to this movie and they all say the same thing - that it sucks. You are now left with two options.
You go to the cinema, and you watch a movie that you will not enjoy.
You don’t go to the cinema, and you do something you will find more fun.
Viewing the problem like this, most of us wouldn’t like it, but we’d reluctantly write off the 10$ we spent on the ticket and do something else. Imagine now, that nobody’s told you that it’s not going to be a good movie. Therefore, you find out it sucks only 20 minutes into it.
Now it gets much more complicated to do the right thing. You drove all the way there, you paid for the ticket, you’re sitting in this nice and comfortable seat. Furthermore, walking out now, would show all these other folks in the cinema that you’ve made the wrong decision to begin with. You’re already so invested in seeing the movie… It’s very hard to walk away.
This inability to see the situation as an outside observer, poses the significant challenge to realize when we’ve fallen pray to the sunk cost fallacy.
How to recognize the Sunk Cost Fallacy
Researchers have found two characteristics that are usually present when one fails to exclude sunk costs from the decision making process. You should look for these clues, and upon recognizing them, you should ask yourself whether you’re currently making the best possible decisions you can.
Being overly-optimistic of the chance of success
One of the clues that you’ve fallen pray to the sunk cost fallacy is when you’re being overly-optimistic of the chance of success in whatever you’re doing.
For example, let’s say that you’ve just spent six hours writing an essay, only to then see that you didn’t take the best approach to begin with.
At this point it would be best to start from scratch using the appropriate strategy. However, it’s hard to admit that you’ve wasted all of this time for nothing, so you’d overestimate the chance that continuing with your current method will be better. If continuing on will take you another 3 to 4 hours, while using the new approach just 2, you will most likely fudge the numbers a little bit, so as to make it seem that keeping up the current strategy is the most rational and best decision.
Or, let’s take the movie example from up above. Once you are already 20 minutes into the movie, you might realize that it’s not a very good movie, and the chance that you will enjoy the rest of it is about 10%. However, just because you’ve already made such a big investment to go see it, you might convince yourself, that this is much closer to 50 or 60%. Because of this, you will stay there, and most likely end up losing your time.
There’s not a foolproof way to realize that you’re fudging he numbers in this manner, because it is mostly done unconsciously. The best way to guard against this is to stay on your toes at all times, and anticipate that possibility. By knowing that it is likely, it is easier for you to spot and avoid.
To notice this sign of the sunk cost fallacy, ask yourself whether you’d give the same probability for a good outcome, if you were not already invested in that outcome.
Letting your personal responsibility of prior decisions affect you
The second sign of the sunk cost fallacy is allowing your personal responsibility in prior decisions to affect you.
This plays a big part in business organizations, where it is likely for a manager to refuse to see that his actions are not really as effective as he’d initially imagined. Even when faced with overwhelmed evidence to the contrary, he might refuse to see through his rose-colored glasses. That is because he has taken the responsibility for the prior decisions that lead him to that point and he hates to admit that he’s done an error.
Or, taking again the movie example from above. Imagine now, that this is a movie that you were very excited to see, so you convinced all your close friends to come out and see it with you. Once you’re all out there, you find out it’s not that good of a movie. Chances are, you will definitely not leave, and chances are, after the movie is finished, you will even say that you kind of enjoyed it. This is because you hold the responsibility for picking the movie and bringing everyone out - it’d really suck to have to admit to have wasted everyone’s time. And leaving halfway through the movie - that is now absolutely out of the question..
To notice this sign of the sunk cost fallacy, ask yourself whether you’d act the same way, if you were an unbiased observer.
The sunk cost principle teaches us to make the most out of our resources, our money, our time, and our energy. It is an invaluable lesson in how to best expand and fulfill our potential.
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