Understanding the Sunk Cost Fallacy: Why It Matters in Financial Decision-Making
Cognitive biases often interfere with rational decision-making, leading individuals to persist in unproductive choices. Among these biases, the sunk cost fallacy is particularly damaging, influencing financial decisions, business strategies, and even personal commitments. Understanding its psychological roots, real-world consequences, and effective ways to counteract it can help individuals and businesses make more strategic, forward-thinking decisions rather than being held back by past investments.
One of the most common challenges we see with investors and small business owners (in many ways, the same mindset) is known as sunk cost fallacy. This is the belief that a poor business or investing decision must (or even can) be remedied with enough effort or additional money spent on it.
This article delves into what the sunk cost fallacy is, its psychological underpinnings, real-world implications, and strategies to mitigate its influence.
What Is the Sunk Cost Fallacy?
The sunk cost fallacy occurs when individuals or businesses continue investing in a decision based on past expenditures rather than evaluating its current and future viability. The term “sunk cost” refers to resources already spent—time, money, or effort that cannot be recovered. Instead of making rational choices based on present realities, people let past investments dictate their next move, even when logic suggests cutting losses.
A Simple Example
Imagine a company that has invested heavily in developing a new product. Midway through development, market research indicates a declining demand for such a product. Despite this, the company decides to continue the project, citing the substantial resources already invested. This decision exemplifies the sunk cost fallacy, where past investments unduly influence current choices.
Another example is when an individual invests in a company that begins having serious financial difficulties, resulting in a significantly reduced stock price. The investor may feel that they should continue to hold that investment, or even add to it, hoping to eventually recover their losses. There is a major difference between holding an investment (or adding to it using the concept of dollar cost averaging) during a broad market correction, and placing undue faith in a single company that is having challenges staying afloat on its own.
Why Do We Fall for the Sunk Cost Fallacy?
This cognitive bias is deeply rooted in human psychology. Several factors contribute to our inability to walk away from bad investments:
1. Loss Aversion and the Fear of Losing Money
People feel losses more intensely than equivalent gains, a concept from prospect theory by Daniel Kahneman and Amos Tversky. Investors often hold onto bad stocks, hoping for a rebound, even when selling would be the wiser choice. Research in the Journal of Economic Behavior & Organization shows investors are more likely to sell winning stocks while keeping losing ones, worsening their financial outcomes. This aversion can lead to continued investment in failing projects to avoid acknowledging a loss.
2. Commitment Bias and the Trap of Past Effort
The more time, money, or energy we put into something, the harder it is to walk away. Businesses continue funding failing projects to justify past investments. A famous example is the Concorde jet project, where governments kept spending billions despite clear evidence of commercial failure. This bias also affects personal decisions, keeping people in unfulfilling careers or relationships simply because they have already invested so much.
3. Fear of Regret and Avoiding the Pain of a Wrong Decision
Letting go of a failed investment often feels like admitting we made a mistake. This fear of regret makes people continue down a losing path rather than face the emotional discomfort of acknowledging a poor decision. Research in behavioral economics suggests that the anticipation of regret influences decision-making more than the actual consequences of the decision.
4. Social and Professional Reputation
Business leaders and investors worry about how abandoning a project may affect their credibility. In corporate environments, decision-makers persist with failing ventures to avoid appearing indecisive or incompetent.
Empirical Evidence
Research has consistently demonstrated the prevalence of the sunk cost fallacy:
- A study published in Psychology & Marketing examined how childhood environments influence susceptibility to the sunk cost fallacy. The researchers found that individuals from lower socioeconomic backgrounds are more prone to this bias due to heightened loss aversion developed during childhood. This suggests that early-life resource scarcity can program individuals to perceive the loss of prior investments as more wasteful, leading to irrational commitment to failing endeavors.
- A study by The Wharton School of the University of Pennsylvania found that firms systematically fall into the sunk cost fallacy, leading to distorted investment decisions. Analyzing acquisitions from 1980 to 2016, the research showed that firms were 8–9% less likely to divest from failing deals if their stock price had risen post-announcement. CEOs who initiated the deals were especially prone to justifying past investments rather than making rational financial choices. This highlights how sunk costs drive firms to persist in unprofitable ventures, ultimately harming performance.
How to Mitigate the Sunk Cost Fallacy
Escaping the grip of the sunk cost fallacy isn’t easy. The weight of past investments can cloud judgment, making it difficult to cut losses and move forward. However, by shifting your mindset and adopting rational decision-making strategies, you can avoid the trap of throwing good money after bad.
Shift from Past Costs to Future Gains
One of the biggest mistakes people make is evaluating decisions based on what they’ve already spent rather than what they stand to gain. Instead of asking, “How much have I invested?” ask, “What is the best decision moving forward?” This small shift forces you to focus on future benefits rather than sunk costs. Research in behavioral finance suggests that those who make future-oriented decisions rather than clinging to past investments tend to experience better financial outcomes.
Set Boundaries Before You Invest
One of the most effective ways to avoid falling into the sunk cost fallacy is to establish clear exit points before committing to an investment, business, or project. For instance, traders set stop-loss orders (this is something we do regularly for our investing clients), define ahead of time what the objective criteria will be for deciding when to enter and exit an investment (with a rule that how we feel emotionally at any given moment will not be one of those criteria), entrepreneurs define key performance indicators, and businesses outline budget limits before launching a venture.
Without predefined boundaries, emotions take over, making it harder to walk away when things go south.
Detach Emotion from Financial Decisions
The stronger the emotional attachment, the harder it is to let go. People tend to persist in failing projects because they feel a personal connection, whether it’s a business they’ve built from the ground up or an investment they’ve defended for years. Viewing financial decisions objectively rather than emotionally can help break this cycle. Many successful investors apply strict risk management strategies, ensuring decisions are based on data rather than personal attachment.
This is important when looking at your financial professional relationships, as well Having a financial advisor who doesn’t always beat the market (none of us do), isn’t necessarily a reason to seek a new advisor relationship. But just being afraid of hurting their feelings when they fail consistently to produce value for you over time, might be a valid reason to consider seeking a second opinion.
Understand That Quitting Isn’t Failing
The fear of being wrong keeps people tied to bad decisions. Admitting that an investment was a mistake can feel like failure, but in reality, recognizing a lost cause and pivoting is a mark of strong decision-making. Some of the world’s top investors and business leaders have walked away from massive projects when the numbers no longer made sense. Knowing when to cut your losses is a sign of wisdom, not defeat.
Evaluate the Opportunity Cost
Every investment should be seen as having both opportunity, and an opportunity cost. Every dollar and every hour spent holding onto a poor investment is a missed opportunity elsewhere. Instead of asking whether to continue, ask yourself, “What better use of my resources exists?” A 2023 study found that businesses that reallocated funds from failing projects into stronger opportunities saw higher overall growth than those that stubbornly persisted with underperforming initiatives.
Seek Outside Perspective
When caught in the middle of a decision clouded by sunk costs, an external opinion can be invaluable. Unbiased feedback from a financial expert, mentor, or even a trusted friend can help you see the situation more clearly. Often, outsiders can recognize when emotions are distorting judgment long before the person experiencing it does (the hard part then, is, overcoming another cognitive challenge: confirmation bias, which is the belief that our opinions and beliefs tend to always be the correct ones).
Conclusion
The sunk cost fallacy is a powerful psychological trap that can lead to poor financial decisions. Recognizing when past investments are influencing your choices allows you to shift focus toward future gains rather than irreversible losses. Whether in personal finance, business, or investing, the key is to approach each decision with clarity and objectivity.
If you’re looking for expert guidance to navigate complex financial decisions, nVest Advisors can help. Our team provides personalized strategies to ensure your resources are working toward your long-term success. Schedule a consultation today and take the next step toward smarter financial choices.
