Don’t Look Back: How to Avoid the Sunk Cost Fallacy
“I want to get my money’s worth.”
On its face, this may seem like a perfectly reasonable way of thinking about costs and experiences. After all, when you pay for something, you expect to get something in return. Otherwise, you might have wasted your money, time or effort—and who likes waste?
But what if you expanded that statement like this?
“This milk is spoiled, but I want to get my money’s worth, so I’m going to make a latte anyway.”
Most people would agree: Getting your money’s worth has its limits.
Life is actually full of situations like this. The trouble is that they often aren’t as easy to parse as a decision not to drink spoiled milk. The line between reasonable and unreasonable can get muddled. If you’ve ever sat through two encores by a band you don’t like just because you paid for the ticket, then you’ve already wrestled with this problem.
At issue here is a behavioral tic known as the sunk cost fallacy. Understanding how it works and avoiding its most pernicious effects can help make you a better steward of your resources and put you on the path toward smarter investing.
A sunk cost is one that is already paid and can’t be recovered. A rational approach to sunk costs is to say that money you can’t get back should have no influence on decisions about what you do next. Only additional future costs should matter. Say you throw $100 into a wishing well and your wish isn’t granted. Would you throw another $100 after it?
Yet sunk costs influence decisions all the time. Whenever you hear a politician railing against a project being canceled just because of the millions already spent, you’re in the presence of the sunk cost fallacy. In fact, this problem is occasionally referred to as the “Concorde fallacy,” after the now-scrapped supersonic jet that once flew between Europe and the United States. The British and French governments continued to spend money on the project long after they knew the economic rationale for it was dead. The money they’d already sunk in the Concorde became its own reason to keep spending more—the very definition of throwing good money after bad.
So what’s going on here?
The desire to avoid waste can sometimes be more powerful than our desire to enjoy ourselves. One study offered up the following problem: Imagine you bought a $100 ticket for an upcoming ski trip to Michigan.1 A few days later, you spend another $50 on a ticket for a ski trip to Wisconsin you think you’ll enjoy even more. Suddenly you realize they are on the same weekend. It’s too late to sell and the tickets are nonrefundable, so you have to choose one. Where do you go to ski?
The rational choice would be to accept that you can’t get your money back and opt for the more enjoyable trip, which in this case would be to Wisconsin. However, a majority of the subjects participating in the experiment opted for Michigan—apparently because that ticket cost more.
Why would the cost outweigh our better interest?
Groundbreaking research by Daniel Kahneman and Amos Tversky showed that humans are imperfect judges of self-interest and have a strong natural aversion to loss.2 In fact, we tend to feel the pain of losses even more keenly than the pleasure of gains.
In the case of the sunk cost fallacy, the fear of acknowledging a “loss” can keep us looking backward at events that we can’t change, when our self-interest lies in thinking about what comes next.
Investing is an inherently forward-looking endeavor. Whether you’re saving money in a savings account, putting it in the stock market or investing in your own business, you’re likely thinking about accumulation, future gains and growth. Sometimes these investments don’t pan out. That can hurt, but what you do next matters a lot.
Throwing more money at a losing investment, trading strategy or business idea in the vain hope of justifying money spent or effort exerted can open the way to bigger losses. This doesn’t mean you should become so indifferent to losses that you take on excessive risk. However, it’s important to always judge your investments according to their future usefulness or prospects, not your past feelings about them. Don’t let the sunk cost fallacy transform that albatross around your neck into a Concorde.
In that spirit, here are a few tips to consider:
- Review your investing strategy at least once a year. Most investments aren’t “set it and forget it,” so you need to make sure your strategy is hitting the marks you’ve laid out for it. Are you still on track? Don’t stick with a strategy just because it’s what you’ve been doing or because it worked in the past. Markets change. You can become more or less willing to take more risks. Your needs can change over time. What worked before might not cut it anymore. Make sure your investments are geared toward the future, not the past. Talk with a professional if you’re not sure.
- Take a hard look at any losing investments and ask whether you could do better elsewhere. When you stick with a losing asset or investment strategy, you’re not just committing to a position that isn’t working out—you’re also sacrificing the potential gains that could come with a different approach. This also applies to any financial advice you’ve paid for. One study found that people who paid for advice tended to value it more highly than free advice, regardless of its quality.3 This is also a kind of sunk cost, as money spent doesn’t necessarily equate to better performance. So be critical with your advisors, too.
- Draft a trading plan before investing. A trade plan is a good way to outline what you’re trying to accomplish and how you’re going to accomplish it. Key elements of your trade plan should include your investing time horizon, entry and exit strategies, position size, and trade performance review. Remember, trading involves losses. The goal is not to win on every trade, but to have more profitable trades than unprofitable trades—in other words, to make more on your winners than what you lose on your losers. (To learn more, see Make a Plan Before You Trade.)
- Use specific order types to exert more control over your trades. Consider using stop orders, limit orders or stop-limit orders to help bring more discipline to your trading. Each order type can be used in particular market conditions to meet certain goals, such as executing trades at prices you specify when markets get volatile.
- Recognize the value in losses. If you have a losing investment in a taxable account, think before you double down. Assets that have lost value can be used to reduce your tax liability through a process known as tax-loss harvesting. This involves selling a losing investment to offset taxable gains elsewhere in your portfolio and buying back a comparable, but not identical position. (For more on tax-loss harvesting, see Reap the Benefits of Tax-Loss Harvesting to Lower Your Tax Bill.)
1Hal R. Arkes and Catherine Blumer, “The Psychology of Sunk Cost,” Organizational Behavior and Human Decision Processes, 1985.
2Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica, 1979.
3Francesca Gino, “Do We Listen to Advice Just Because We Paid for it? The Impact of Advice Cost on its Use,” Organizational Behavior and Human Decision Processes, 4/2008.
What you can do next
- Listen to more episodes of Choiceology, a podcast about the psychological traps that lead to expensive mistakes.
- Do you trade frequently? Enroll in Schwab Trading Services and review your trading plan with a Schwab trading specialist.
- Need help planning for retirement? Consider Schwab Intelligent Portfolios PremiumTM, our unique approach that combines professional advice with automated investing.