Let’s start with a story – in fact, it was an experiment done by Richard Thaler, which was narrated by Daniel Kahneman in his famous book ‘Thinking Fast and Slow‘. Thaler asked this question to a few peoople:
“Two avid sports fans plan to travel 40 miles to see a basketball game. One has paid for his ticket; the other was on his way to buy it when he got one free from a friend. A blizzard is announced for the night of the game. Which of the two ticket holders is more likely to brave the blizzard to see the game?”
If you are like me, the answer will likely be – “the person who paid for his ticket will go and see the game.”
But, think again.
Why would he brave the blizzard? Why not stay at home?
The reasoning goes like this – he would go to the game, because he paid for it. So, if he misses, it will be a loss. Really?
The cost of ticket is already paid for. We can’t change that fact. It is a sunk cost.
All that matters now is – whether he should take the risk of going out in the blizzard. He should ask himself: “if this ticket was free, would I have braved the blizzard to see the game?”
Mortals like us will find it difficult to ask such questions to ourselves. We’re wired that way. We keep thinking about the past – which we cannot change – and do things that are not optimal. We keep regretting. Does that help? We know, it doesn’t.
A common example is – being in a bad relationship, just because we have invested so much time and effort to make it work. We keep hoping that things will get better, even if it hasn’t worked out well so far despite your best efforts. In doing so, we are foregoing better relationships that we could have had – if we had let go of the past, and focused on the future. The better relationships that you let go in order to stay put in the current bad relationship is your opportunity cost.
The question you should ask yourself is: “will I get into similar relationship now, that does not seem to work?”. If the answer is “no”, get out of it. Makes sense?
The mental bias of thinking about the past – which we cannot change – is called sunk cost fallacy. This term originated in economics – which defines sunk cost as a cost that has already been incurred and cannot be recovered. As we have seen, it is applicable in life as well.
This happens mostly because we don’t want to be seen as having done a mistake. If we understand that the relationship is getting worse, and decide to get out of it – it means that we did a mistake of getting into a bad relationship. We just can’t accept that.
In business and investing
Once an investor buys a stock, he tends to think of the purchase price as one below which he should not sell. But the truth is that, after you bought a stock, the purchase price is irrelevant. Keeping the purchase price in mind does not help you get a better return, does it? No way!
Say, you invested $100k in company A’s stock. After two months, the stock tanked to $60k. You investigate the current situation of the company. It becomes very clear that your initial investment thesis was wrong. What to do?
You are staring at realising a loss of $40k – that too, in just 2 months’ time. Not only that you have to feel the pain of loss, you will also look like a fool. It is very likely that you will try to hold on to the stock. But, what do you lose here?
There could be better investment opportunities in the market – say, company B’s prospects are looking quite good, and its stock can be expected to produce a CAGR return of 10% for the next 5 years. By not accepting the error and staying put in company A’s stock, you are incurring an opportunity cost – the returns you could have earned from company B’s stock.
The question you should ask is: “will I buy this stock now?”. If the answer is “no”, sell it.
In a similar way, businesses tend to keep throwing good money after bad at projects that now appear to end up as loss-making. They do this just because the company has invested significant time and money in building the project to its present stage. Managements should realise that, what they have invested so far is sunk cost, and there is nothing they can do about it. All they can do is, to look at the future and ask: “if I invest this much of money in this project, will it yield satisfactory results?”. If the answer is “no”, abandon the project.
Similarly, for philanthropic projects, ask: “if we put in this much of effort, will we be able to achieve our objectives?”. If the answer is “no”, quit.
So, what is the remedy?
Accept past as past, and focus only on the future.
As a student or artist or employee, we all go through times when we hate what we do, and later change mind and come back to loving it.
Imagine that you love researching on stocks. But, after working in the industry for 5 years, your passion start to wear off. You find it emotionally difficult to get up and go to office everyday. If you realise that the five years you invested in the industry are sunk costs, it looks like, it might be a good decision to quit and do something else you really like. But, while taking such important decisions, we should make sure that our current dislike for the career path is not just temporary.
In a relationship – which is in bad shape – wait for some time to see whether it can be fixed. If not, get out. Cut your losses.
Likewise, we should not give up on our critical life goals just because we temporarily lose interest. Therefore, wait for some time – but not too long – before you take the big decision.
Sandeep Baliga of and Jeffrey Ely of Kellogg opine that humans have a tendency to forget the original reasoning behind their decisions. Hence, past decisions can serve as mental placeholders that can remind us of why we decided something.
Furthermore, we need to keep in mind what went wrong in our past decisions – so that, we can be more careful in the future. Learn from past mistakes.
You don’t have to prove to anyone that your past decisions were right. You just have to take the right decision now, based on available information. Forget the past, focus on the future.
Take lessons from past mistakes. But it should not be an obstacle for a better future.
Wikipedia: Sunk cost
Psychology Today: Letting Go of Sunk Costs
Kellogg School of Management: Is the Sunk Cost Fallacy Actually Smart Business?
Featured image: Pixabay