Sunk Cost Analysisis a way of making decisions that ignores any costs that have already been incurred and cannot be recovered. These costs are known as “sunk costs.”
The key principle of sunk cost analysis is that only future costs and benefits should be considered in a decision, not past expenditures, since the latter cannot be changed and should not influence the rational assessment of a viable option.
Example 1
Jessica has invested a total of $500,000 into her store, including a significant loan of $300,000 she took out to expand her product lines and refurbish the store interior to make it more appealing. The business, however, has been losing money steadily for the past two years, with total losses amounting to approximately $200,000.
The store is currently losing around $5,000 a month. Jessica is emotionally attached to her business and deeply invested in the community. Despite the financial losses, she continues pouring money into the business, hoping that the next season’s fashion trends or another big marketing push will turn things around.
Sunk Cost Fallacy
Jessica is exhibiting the sunk cost fallacy by continuing to invest in her failing store purely because of the amount she has already spent, rather than considering the likelihood of the business becoming profitable in the future.
Sunk Cost Analysis
A business consultant meets with Jessica to discuss her situation. After reviewing the financials and the market trends, the consultant advises Jessica to critically assess whether there are realistic signs of improvement. They ask Jessica:
- What changes have you seen in the market or in your business model that would justify continued investment?
- Is there a clear and realistic plan that shows the store can not only stop losing money but actually start generating a profit within a specified timeframe?
- Have you considered alternative strategies, such as transitioning more of your business online or downsizing to reduce overhead costs?
The consultant emphasizes that Jessica needs to make her decision based on potential future returns, not past expenditures, and suggests she might need to consider closing the store if there is no viable path to profitability. They also discuss the option of selling the business or pivoting to an online model to mitigate losses.
This scenario demonstrates how the sunk cost fallacy can impact decisions and highlights the importance of sunk cost analysis for making rational business choices based on future potential rather than past investments.
Example 2
Two years ago, Mark invested $50,000 in InnovateTech stocks when they were priced at $100 per share, hoping the stock would continue its upward trajectory. Unfortunately, due to unexpected regulatory changes and stiff competition, InnovateTech’s stock value started to decline significantly.
The stock is now worth $30 per share, and Mark’s initial investment has dwindled to $15,000. Despite the stock’s poor performance and bleak outlook from financial analysts who predict further decline due to ongoing issues within the company and the tech industry, Mark continues to hold onto his shares.
Sunk Cost Fallacy
Mark is reluctant to sell his shares at a loss, hoping that InnovateTech’s stock will rebound so he can recover his initial investment or at least minimize his losses. He thinks, “I’ve already lost so much, I need to wait until the stocks go back up to $100 or at least close to that before I sell.”
Sunk Cost Analysis
A rational approach would require Mark to consider the current situation and future prospects of InnovateTech independently of his past investment. Here’s how he might think if he avoids the sunk cost fallacy:
- Market Analysis: Are there signs of potential recovery for InnovateTech, or is the market trend indicating further decline?
- Opportunity Cost: What are the opportunity costs of holding onto InnovateTech stocks? Could investing this money elsewhere yield a better return?
- Cutting Losses: Sometimes, realizing a loss is necessary to prevent further financial damage. It’s important to have a stop-loss strategy in place.
A financial advisor might counsel Mark to assess the performance of InnovateTech based on current market conditions and future outlook, rather than his emotional attachment to his original investment.
The advisor might suggest:
- Diversify: Reduce the risk by diversifying investments rather than relying heavily on a single stock.
- Set Stop-Loss Limits: Establish and adhere to stop-loss levels to prevent greater losses.
- Reassess Investment Goals: Consider whether the current strategy aligns with his long-term financial goals.
By focusing on these rational investment strategies rather than the sunk costs of his initial investment, Mark can make more informed decisions that could potentially salvage his portfolio or prevent further losses. This example showcases how the sunk cost fallacy can cloud judgment and lead to poor investment decisions in the stock market.