By Paul Kim
Feb. 4, 2022
Imagine someone has created a new way to make donuts by boiling and baking the dough instead of frying it, and you want to be among the first to try it. You're thirty minutes into waiting when you realize that it will take another hour to get to the front of the line. You've also realized that a boiled and baked donut is just a bagel. However, you've already sunk time into waiting, so you decide to see it through, even if the end result isn't worth it.
- The sunk fallacy cost is when you make future decisions based on how much time or money you've already spent in the past.
- This fallacy is often related to other behavioral biases, such as commitment bias and loss aversion.
- The sunk cost fallacy can affect how you spend money as well as how you invest.
This is a prime example of the sunk cost fallacy in action, making decisions based on previous costs — in this case, the time it's taken so far to wait in line for your donut-turned-bagel.
This bias can also be applied to your finances and investments, where it can have larger consequences than two hours and a bagel.
What is the sunk cost fallacy?
The sunk cost fallacy is a cognitive bias where you're likely to spend more on a decision now or in the future, based on how much you've spent in the past. Because you've already committed to the cost — whether that's time or money — you're now more likely to follow through on whatever it is that you've invested in, regardless of the outcome.
The sunk cost fallacy is partially caused by commitment bias, in which people are unwilling to change what they've done in the past, as well as loss aversion, in which people are more conscious about potential losses than potential gains. These biases are generally more applicable to retail investors, who are closer to their money than an institution and thus more emotionally invested in their shares.
Examples of the sunk cost fallacy
You can find the sunk cost fallacy in your finances in two main areas: cash flow and investments.
Cash-flow decisions: Sunk cost fallacies around cash-flow decisions often revolve around committing to a purchase because you've already spent nonrefundable money. Perhaps you've bought a ticket to an outdoor music festival. You learn that there's going to be rain on the day of the festival, though not heavy enough to cancel the concert so you can't get your money back. Because you've already spent money on the ticket, you might be inclined to go to the concert, even if you know you won't enjoy it.
In an extreme example, you might feel the need to go through with a real estate purchase or an apartment rental because you've already put down earnest money or a security deposit.
Investment decisions: When it comes to investments, the sunk cost fallacy can keep you attached to a failing investment because of the time and money you've already invested. You might've decided to invest in an industry you believe is growing. However, while you were right, the specific company whose shares you bought is actually losing money while similar companies start to see returns. It doesn't look like that company will ever catch up with its industry, yet you hold onto your shares without any quantitative reason, just the fact that you already invested time and money into it, and selling would be a loss.
How to recognize you're stuck in the sunk cost fallacy
If the price of one of your holdings drops, it can be difficult to distinguish between falling victim to the sunk cost fallacy and holding onto a stock that might not be doing well at the moment. According to Cait Howerton, CFP® professional and lead financial planner at Facet Wealth, the determining factor is your reasoning for holding that investment.
"It really comes down to market fundamentals of a particular holding. Is there an actual chance for this holding to go back up," Howerton says. If you cannot point to a reason to hold onto a stock beyond optimism and the fact that you're already invested, it might be time to diversify out of that stock regardless of what you've already put into it.
You can also measure an investment against your long-term investing plan. If your holdings in a certain company fall out of line with your overall investment plan, you might be holding onto them for irrational reasons, such as the sunk cost fallacy.
How to avoid falling into the sunk cost fallacy
To be able to measure an investment against your long-term investment plan, you first need to have a long-term investment plan. When you create a plan, it is important to have a long-term goal. This goal should be toward something an achievement such as retirement or a home rather than a particular dollar amount you want to see in your returns. Once you start basing goals on an amount of returns, you are once again making decisions based on what you've spent in the past.
Additionally, you want to have predetermined exit points for your investments such as exiting if a stock drops and hasn't made a comeback after a certain amount of time or diversifying out of an investment at regular time intervals if it makes up a certain percentage of your portfolio.
Note: An investment into one stock should never exceed 10% of your portfolio. It is easier to fall into the sunk cost fallacy if the price of that stock were to drop.
Howerton says the best way to create these plans is to find a financial planner. "As a financial planner, I work with a financial planner, because I can't have objectivity," she says. She adds that when that plan is put together, there shouldn't be a need to check in on it very often.
"If you have a set-it-and-forget-it, long-term investment plan, there's no reason to be looking at it every day and cause yourself that anxiety," she says. "Check in on a scheduled timeframe so that you're not being as triggered and pulled into making decisions when you shouldn't be."
Subscribe to Business Insider's Financial Insights Newsletter
This Business Insider article was legally licensed by AdvisorStream