The best way to describe what is the sunk cost fallacy is with an example.

Let’s assume the following situation: You have two stocks in your portfolio, one that went down 10% and one that went up 5%. Which one would you would put more money in? Will will, with the idea that we have to buy low and sell high, choose to invest in a stock that has fallen 10%? If you do that, you may be suffering from the sunk cost fallacy.

But what is the sunk cost fallacy?

The decision to invest additional funds in a losing account when better investments are available is known as the sunk-cost fallacy. The main idea is that you already have a cost (the 10% loss) and that influences your decision.

A rational decision-maker is only interested in the future consequences of current investments and not what happened in the past. As Seth Godin says, the past is a gift from your old self to your current self, you (the current self) can do what you want with that gift, even throw it in the trash.

Let’s use a different example, imagine a company that has already spent 50 million dollars on a project. The project is now behind schedule and the prognosis for its final payoff is less favorable than in the initial planning stage.

An additional investment of 60 million is required to give the project a chance to succeed. An alternative proposal would be to invest the same amount in a new project that at the moment appears likely to bring a greater return.

What will the company do? It’s not uncommon for a company afflicted with sunk costs to go around throwing even more money out the window, rather than accepting the costly failure.

Another example: there will be a concert by a musical band in the city. Your friend won the ticket but you had to pay $ 100.00 for the same ticket. You were going to the show together in the same car and unfortunately, the car breaks down halfway.

Who would be more willing to do whatever it takes to get on the show? Probably you, because you have sunk costs (spent and therefore you tend to want to “make that money worth”).

We have to always be aware in our decisions, whether in investments or not, about sunk costs. We have to look to the future and (try to) forget what happened in the past (sunken cost) and look only for the future.

The sunk cost in companies

The increasing commitment to efforts doomed to failure is a mistake from the company’s perspective, but not necessarily from the perspective of the executive who is the “owner” of the project that is about to sink.

Canceling the project will leave a permanent stain on the executive’s résumé, and his personal interests may be better served if he continues to gamble with the organization’s resources in the hope of recouping the original investment—or at least in an attempt to postpone the day of the deal. accounts.

In the presence of sunk costs, the manager’s incentives become misaligned with the goals of the company and its shareholders, a familiar type of what is known as an agency or representation problem.

Boards of directors are well aware of these conflicts and often replace a CEO who is hampered by old decisions and is reluctant to cut costs. Board members do not necessarily believe that the new CEO is more competent than the previous one.

What they do know is that this new person does not bring with them the same mental accounts and is thus better able to ignore the sunk costs of previous investments in evaluating present opportunities.

And finally

“The sunk cost fallacy keeps people too long in bad jobs, unhappy marriages, and unpromising projects.”

Happy investing!

This post was based on the book Thinking, Fast and Slow by Daniel Kahneman.