Step 1: Make Smarter Decisions by Accepting Sunk Costs

Step 1: Make Smarter Decisions by Accepting Sunk Costs

One cognitive bias in human decision-making is the sunk-cost trap, or escalation of commitment. Over the past forty years, there has been lots of research focused on sunk costs and their effects on human behavior. The sunk-cost trap is a tendency for people to escalate commitment to a course of action in which they have made substantial prior investments of time, money, and other resources. With high sunk costs, people become overly committed, even if the results have been relatively poor. They have a hard time cutting their losses. Alternatively, they keep investing because the initial investment was so large and the situation continues to escalate. I’m sure you can think of both business and personal situations in which you have doubled down on a failing investment due to high sunk costs.

On a personal level, a classic example of where we ignore sunk costs is with gym memberships. People sign up for a gym membership with good intentions at the beginning of the year (i.e., New Year’s Resolutions) and find that by spring they are no longer a visiting member. Each month you vacillate between canceling and continuing the membership when you pay the fee. Most people continue to pay the fee with intentions of starting a new gym routine the following month. The reality is, the majority of people never get back to prioritizing the gym. We rationalize the expense by thinking that if we continue to pay the monthly fee, we will get back to the gym, but it rarely happens that way. In fact, the entire gym industry is built on this sunk-cost cognitive bias. I have seen statistics that between 67%-90% of people with gym membership stop going after 90 days. I once owned a fitness center and watched people struggle with this bias every month. When I was on the other side of the equation, I could knowingly use this cognitive bias to grow my business.

In a business setting, we frequently continue to invest in programs that we intuitively and analytically know are not delivering the return we need. Rather than accept the loss of the program’s sunk costs, we continue to invest and push the program forward. We throw more resources at the failing program to prove we can get it back on track.

I’ll spare you my lengthy diatribe about the Chicago Bears’ inability to overcome the sunk cost of quarterback Jay Cutler. Management decided to go all in and extend his contract ($126.7M extension) even though his performance was sub-par. Why? They could not ignore the sunk cost of the original Cutler investment and decided to make a grand investment, which is eroding and disenfranchising the fan base.

We ignore sunk costs for several reasons. Sometimes, it’s for political reasons and to save face. Another rationale for ignoring sunk costs is based on prospect theory. That is, if you are in a losing situation, you tend to take more risks on the prospect that you will eventually win and end up in the black. We become gamblers to save our investments, as opposed to objectively accepting the loss and walking away.

With the sunk-cost trap, you set up a rule (go to the gym, yield an x% return, etc.), and then ignore that rule. This is a detriment of the human mind.

How can you overcome the instinct to ignore sunk costs?

  1. Become aware of your propensity toward sunk-cost bias and start thinking about how it may affect your decision-making abilities. Be cognizant of your emotions and objectively consider cutting your losses and moving on.
  2. If you have invested in a learning vendor (LMS, content, measurement, etc.) who is not delivering what you expect, you need to renegotiate the terms of your contract or assess the value of the sunk cost vs. the results you need.
  3. The fear of a negative social stigma makes us unwilling to admit a loss or failure. You need to allow yourself to make mistakes, but you must recognize mistakes and use them as learning opportunities.
  4. Do not only focus on the cost or investment you lost (negative), but highlight the savings (positive) you made by intelligently self-correcting.
  5. Don’t waste any more of your time; start down a new path as quickly as possible. Time is an unrecoverable asset.
  6. When possible, get feedback on your decision options so you don’t repeat past mistakes. Also build in a mechanism for rapid feedback on decisions you make in the future.
  7. Employ unbiased, third-party experts. Outsiders bring a fresh perspective. They don’t have the same reference points or emotional attachments to investments and projects. They also lack your preexisting hypotheses and the political egocentrism.

Smarter People Planning protects you from falling into cognitive traps by offering an objective outsider perspective and alerting you to potential pitfalls.

What business decision are you going to change now that you’re aware of the sunk-cost trap?

 

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