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Know When to Walk Away – The Sunk Cost Fallacy

sunk costs do not = financial decisions

We’ve talked about a few of the problems that business owners fall prey to. A failure to plan, poor budgeting of time and resources or starting off in the wrong business structure. Those instances when we know things aren’t going quite right, but bull ahead anyway and fall victim to the imaginatively named Sunk Cost Fallacy.

In economics a sunk cost is simply a cost that has already been incurred and cannot be refunded, and should be excluded from further decision making as it has no impact. Regardless of what we decide, the money/time/effort has already been spent.

The Sunk Cost bias (and Fallacy) is when we believe and act as though the sunk cost does have an effect on the decision.

X has already been invested in project Y.

Z more investment would be needed to complete project Y otherwise X will be lost.

Therefore, Z is justified.

Some of these traps are obvious, even if only in hindsight:

  1. Spending $5,000-$10,000 to fix a $500 lemon of a car.
    “I’ve already bought the car so I should keep using and repairing it. Otherwise that $500 would have been a massive waste.”
  2. Escalating commitment (and investment) in a doomed project ala Concorde.
    “If I back out now then all those people who doubted me will laugh and say ‘I told you so’.”
  3. Staying in a dead-end career or degree because you’ve already spent years in it.
    “If I try to change now I’ll have to spend all that time and money all over again.”
Not sure if I should back out now - or stay because I've invested this much time already

Other sunk cost fallacies are harder to spot;

  1. Finishing the steak dinner you paid for, even though it’s cold and the texture of old boots.
    “I paid for this so I’m damn well going to finish it.”
  2. Holding onto clothes for years without wearing them.
    “Neon green leg warmers are guaranteed to come back into fashion. If I throw them away now I’ll have to buy them again.”
  3. You get the idea.

Sunk Costs ≠ Giving Up

Don’t get us wrong, we are not saying to throw in the towel at the first sign of trouble, far from it. Persevering through difficulties is one of the key characteristics of all great business owners and leaders.

However if you decision process hinges on; justifying the previous costs, ignoring the opportunity costs and, pushing blindly onward without a plan or accountability…

Then you are guilty of the Sunk Cost Fallacy.

How Can You Avoid the Sunk Cost Fallacy?

Understand the True Cost/Benefit of Continuing/Changing Course

To continue with the earlier car example;

If you could get a different car, with working air-conditioning and real seats for $3000, then that is the better decision. The choice isn’t between the $500 car and the $3,000 car, as the $500 has already been spent. The real choice (and real Cost/Benefit) is between the $3,000 new car and the $5,000-10,000 repairs.

Alternatively, if there are no other options available, or if the loss of the lemon and time cost of replacing it would cause you to lose your job, then continuing to fix the car is the better choice. The loss of the job increases the cost of replacing the lemon exponentially, over and above the cost of the repairs. Even in this situation however, the $500 doesn’t have an impact on the decision process.

Separate Your Pride From The Decision

Do you genuinely believe that this choice will ‘come good’ in the end?
Or are you simply trying to prove that you were right, even if it commits you to a potentially disastrous course of action? 

People may snicker when they hear that you’re pulling the plug on your new product or business. But if your “Bottled Water for Goldfish” product ends in bankruptcy they’ll laugh themselves sick.

Remember Why You Made The Initial Investment

No-one deliberately and willingly invests significant amounts of time, effort or money (like starting a business) expecting to lose everything. We always have a particular goal in mind, whether that’s a fulfilling career, a name-brand business or a house with all the trimmings. When your  investment’s trending away from that goal, and you can’t see a way to get it back on track, that’s a good time to sit down with your advisor, and develop either a plan to get back on track, or a way to intelligently cut your losses.

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