Knowing how to prevent this fallacy can be the difference between your company sinking or swimming!
Sunk cost fallacy refers to a situation where an irrecoverable expense (“sunk cost”) has been made and is used as a justification to continue that endeavor, no matter how futile it may be. Almost all of us have made irrecoverable expenses in our day-to-day lives, like buying tickets to a film or a concert. So, if you choose to sit through a bad movie because you have already paid for the tickets, thereby wasting money and your precious time, it would be an example of a sunk-cost fallacy.
Sunk cost fallacy isn’t a situation only you and I experience. Startups deal with it, too. At times, the most well-thought-out business decisions don’t yield the right results, leaving company leaders to make a choice— to stick to their plans or back out and save money. To make that choice a little simpler, here is a breakdown of why we fall prey to sunk cost fallacy and how you can avoid it.
What leads to sunk cost fallacy?
Sunk cost fallacy can be a result of the following psychological factors—
Loss aversion
A startup founder, in this case, would be more likely to devote more resources to a bad decision because of loss aversion. Think of it this way, you buy stocks of a company, but they don’t seem to be doing well. So, instead of selling it for a loss, you buy more in the hope of positive returns later. The same is the case with startup founders who become loss averse with the projects they are working on and continue to stick with them, hoping that things would turn around if more investment is made.
The framing effect
The framing effect is a cognitive bias where a person makes choices based on how the choices have been presented to them as opposed to relying on information to make a sound decision. The best example of this is half a glass of water. Some would consider that glass half empty, while others would look at it as a glass half full. In a similar vein, think of a startup founder who just spent thousands of dollars on a blog campaign only for it to not yield the desired amount of interest in the company. In such a situation, the founder might be inclined to put more money into the blog campaign to push it further (and make it the success they expected) instead of shifting to other promotional methods.
Waste avoidance
A lot of decision-makers always try their best to waste as little of company resources as possible. However, it is nearly impossible for every project that your company undertakes to be equally successful. So, when it comes to business decisions, particularly those taken during the research and development stage, it is best to cut your losses before the waste you are trying to avoid becomes even bigger. A good example of this is what happened with Intel back in the 1970s. At the time, the company used to make memory chips but soon began experiencing tough competition from Japanese memory chip manufacturers. So, they pivoted and began producing microprocessor chips to avoid wasting more resources in a market where they were losing ground. However, they did waste a lot of time coming to that decision and that was because of the sunk cost fallacy.
How to avoid sunk cost fallacy
According to a study conducted by the Harvard Business Review (HBR), the more professional experience (as opposed to general intellectual capability) that a person has, the less likely they are to fall victim to the sunk cost fallacy. Simply put, being smart isn’t enough. You need to be a seasoned decision-maker to avoid this fallacy. So, if you feel like you are likely to give in to the psychological patterns we discussed before, just know that your proclivity to do so might reduce over time.
As for avoiding this fallacy, if you have read this article so far, you have already taken the first step in that direction. That is, you have become aware of what it is and what leads a person to make decisions that are not financially beneficial to their company. The next thing you should probably consider is using data as the basis for all your business decisions.
This data can be obtained by setting clear goals for what you intend to achieve from a project and measuring the success of the project based on key performance indicators (KPIs). As long as you keep tabs on the projects your company is working on, you can catch this fallacy before it gets out of hand. Each review of the project can be used as a checkpoint to see whether the current way of doing things is actually yielding positive results or not. Changes can be made accordingly.
Why is it so important to avoid this fallacy?
The sunk cost fallacy can lead you to devote time, money and labor to a project that isn’t going to pay off. As a result, you might fall behind other companies that occupy the same market segment you do. If you don’t let go of a failed project in time, your employees might also lose trust in your decision-making abilities, thus bringing down company morale and productivity.
This fallacy can lead to a vicious cycle that can be the downfall of your business, so, entrepreneurs need to accept failure as a stepping stone to success. Business leaders need to be forward-looking and make decisions for the company without being weighed down by the sunk costs it has incurred so far. Remember that your failure doesn’t have to define you, it can instead make you a wiser decision-maker and a more capable entrepreneur in the long run.
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Header image courtesy of Envato
