Navigating the Sunk Cost Fallacy

Ah, sunk costs. They can totally mess with our brains, hence the “sunk cost fallacy.” If you’re not familiar with the expression, here’s how Wikipedia describes it:

More recently the term sunk cost fallacy has been used to describe the phenomenon where people justify increased investment in a decision, based on the cumulative prior investment, despite new evidence suggesting that the cost, starting today, of continuing the decision outweighs the expected benefit. Such investment may include money, time, or even — in the case of military strategy — human lives.

I find myself applying this often to reading or other forms of entertainment. If I’m reading a boring book, I stop. If I’m not excited to pick it up again, I don’t. The sunken cost is my time invested up to that moment and the $9.99, neither of which is justification for me continuing to read something I’m not interested in. On a daily basis I apply this all the time to articles. I’ll also apply it to movies and TV shows. The key is not to feel guilty just because you spent some time or money on the entertainment in the past, and instead feel positive about the fact that you just freed yourself up to do something better with your time.

A book is one thing, a big business decision is another. What if you spent $10k investing in a new line of products that isn’t selling? Do you re-purchase inventory and then invest more time and effort promoting it, or do you blow out the products and move on? If you’re asking the question, the correct answer is almost always the latter. But that’s a much harder decision than it should be because you naturally think “just give it some more time and all of our effort will pay off.” It doesn’t have to be a line of products either, the same goes for an employee or an app or really anything that you’ve invested time or money in that isn’t meeting expectations.

Over the past few years my partners and I have gotten much better at doing this. A few techniques really help. The first is to openly identify sunk costs when making a decision and recognize that they are in fact sunk so they should play almost no factor in our decision. It helps when the person least involved in the decision does this. Since they have less skin in the game they’re most likely to objectively identify what’s really a sunk cost and what isn’t.

The other technique is to look at it from the perspective of someone who hasn’t incurred those sunk costs. Some questions we ask:

  • If a respected business adviser who had only our best interests in mind had to make this decision, what would they recommend? If that same person bought our company today, what would they do?
  • If I was asked to advise a company with this problem, what would I recommend?
  • If Mark Cuban / Marcus Lemonis / [insert famous angel/VC] bought a stake in our company and had to make this decision, what would they decide?

It also helps to explicitly quantify the sunk costs and just what it would take to overcome them in the future. For example, we have a Clearance section on Detailed Image. We’ve created a report that suggests clearance products for us. It looks at how much inventory we have in stock, how long we’ve had it in stock, the ongoing carrying cost of that inventory, future forecasts for the product, and the opportunity cost of investing that money in a new product that sells as good as our median product. The math doesn’t lie. Sometimes we’re surprised by what’s on there. Ultimately the decision of what to put on clearance is made by us, but when you have the math in front of you it takes more work to explain away poor sales. Instead of asking “why should we get rid of it?” we ask “why should we keep it?”

Easy? No. The only factor? No. But I do believe that considering sunk costs has made me a better decision maker personally and us better decision makers as business owners.