The fallacy of sunk costs
A ‘sunk cost’ is defined as a cost that has been made in the past, and has no influence or effect on any future decisions. ‘Water under bridge’ is an often heard English saying that refers to sunk costs, meaning that you shouldn’t dwell in the past over past choices, and instead look ahead and focus on the future.
For example: let’s say I have invested USD $25,000 in a college fees to enroll in a first year of a law degree. After one year, I decide law is not really my cup of tea after all, and I feel like changing to another future profession. However, I would be very hesitant to pay a new USD $25,000, because I have the feeling I just threw away the exact same amount. Apart from the fact whether I can afford that additional USD $25k, I would be extra careful to invest in the next step of my future because of the money that is ‘down the drain’ already.
However, this is a fallacy because in the end, your future path is only determined by decisions you make now, that will affect the future. You should consider those $25k as lost forever, and not part of the equation to make a decision about the future.
Or, consider this example (originally found on Medium, written by Dr. Arif Akhtar):
“As the president of an airline company, you have invested 10 million dollars of the company’s money into a research project. The purpose was to build a plane that would not be detected by conventional radar, in other words, a radar-blank plane. When the project is 90% completed, another firm begins marketing a plane that cannot be detected by radar. Also, it is apparent that their plane is much faster and far more economical than the plane your company is building.”
The question is: should you invest the last 10% of the research funds to finish your radar-blank plane?”
Answers: Yes: 41 No: 7
“As president of an airline company, you have received a suggestion from one of your employees. The suggestion is to use the last 1 million dollars of your research funds to develop a plane that would not be detected by conventional radar, in other words, a radar-blank plane. However, another firm has just begun marketing a plane that cannot be detected by radar. Also, it is apparent that their plane is much faster and far more economical than the plane your company could build.
The question is: should you invest the last million dollars of your research funds to build the radar-blank plane proposed by your employee?”
Answers: Yes: 10 No: 50
You see how the amount of people that answers ‘yes’ is way higher when the investment already has been done (Question 1). However, that’s completely irrational as historical decisions don’t matter, in this case. In both cases, the chance the airplane of the opposing side will win, is equal.
Innovation projects and sunk costs
Often, we see innovation projects get allocated a certain budget. For example, let’s say 10 projects equally get USD $5 million allocated over one full year. So, let’s say all of these 10 project ‘fail’ at at the end of that year, not yielding the results that were envisioned. However, we do have one project (that had an initial investment of USD $500k) that shows potential for future success: an additional year of funding could potentially turn this project around, for the good.
The sunk cost fallacy kicks in when the sponsor of this project would think: “I’ve just lost $5 million, why would I invest more after virtually all projects failed?” However, this is an emotional response to the situation, and he should think about the future of the business and his chances for success, and would be better off by investing again in the most promising project of the 10.
The alternative — killing everything — would be an emotional response rather than a rational one. (For argument sake we’ll imagine this sponsor has deep pockets and is able to spend more than the $10 million he already put in.)
Instead, if he really wants to help the business forward, he should open his wallet and invest (again) — albeit a counter intuitive action.