What is... | November 14, 2012

What is the sunk cost trap?

You have bought a ticket to a movie that – part way through – turns out to be very boring. Do you stay in the cinema until the ending credits roll, with the ambition of getting your money’s worth? Or do you dismiss the price paid for the ticket, leave and enjoy the extra time in a different way?

The question strikes at the heart of the “sunk cost trap” – or the tendency to irrationally continue with something because money, time or effort has been invested in it. The sunk cost fallacy can apply to relatively insignificant circumstances (such as the cinema visit or whether to throw out unworn clothes) as well as much larger financial and non-financial choices (such whether to sell your car or loss-making shares or, for governments, continue with failing policies).

It can, for example, help explain why people hold on to investments that have made a loss and find it difficult to sell a house if its price has fallen below the original purchase price. As a result, it can weaken an individual’s finances.

Don’t look back
Moviegoers, investors and others would, if behaving rationally, not get bogged down thinking about how much they have already spent on a ticket, share or other item. Instead they would look forward and choose the path that gives them the best future. But researchers say people do not always act rationally. Sunk costs can skew choices.

Ohio University academics wrote that part of the reason maybe a misplaced desire to not appear wasteful. Dutch researchers found people who were more generally able to let go of past events were less likely to succumb to the sunk cost trap. Age may also play a role, with older people less subject to the effect.

Also known as the “Concorde fallacy”
A more striking name for the sunk cost trap is the “Concorde fallacy” – in reference to the development of the supersonic Concorde jet back in the 1960s and 70s. Academics write that it was known “long before the plane was completed” that the Concorde’s financial prospects were dim. The financing governments continued the project anyway “on the grounds that they had already invested a lot of money”. The Concorde ultimately ceased flying after a fatal crash in 2000.

The sunk cost effect is closely related to other thinking traps, such as the endowment effect and the disposition effect, explored by academics such as Nobel Prize recipient Daniel Kahneman, Amos Tversky and Richard Thaler.

Time to cut your losses?
Economist Chris Dillow blogs for eZonomics that people who lose money should try to forget about it. “We should recognise that past losses – on horses, houses or shares – can be considered irrelevant. What matters more are prospective gains and losses, not past ones,” writes Dillow.

However, this is easier said than done. An eZonomics poll on whether respondents have sold underperforming investments in the past year says strategy will vary from person to person and depend on circumstances. But a helpful habit is reviewing investments on a regular basis.

InvestingBiasHouse buying

eZonomics team
.(JavaScript must be enabled to view this email address)