Sunk Cost Fallacy | Pocket Byte #18

Why do smart people make irrational financial choices? Why do we stick with doomed projects, failing investments, or toxic commitments, just because we’ve already spent money, time, or energy on them? You’ll learn the psychology behind sunk costs, including loss aversion and cognitive dissonance.

Episode Transcript

(00:00):
Welcome back to another episode

(00:01):
of the Wealth Effect.
I'm your host,
Green Moon.
Today, we're talking about a cognitive
trap that affects us all and is one of my
favorite economic concepts
I learned in college.
The sunk
cost fallacy.
Have you ever stayed in a terrible movie
just because you already
paid for the ticket?
Or continued a project you knew was doomed
simply because you had already invested so

(00:23):
much time and
money into it?
If so, you've experienced
the sunk cost fallacy.
This is the tendency to continue an
endeavor, not because it's a good idea,
but because of a
past investment.
We're going to explore why we fall
for this trap, and most importantly,
how to escape it.

(00:44):
Let's fill
your pocket.
Section 1.
Origins.
Let's start with what exactly
is the sunk cost fallacy.
In traditional economics, it's a cost
that's already been incurred
and cannot be recovered.
Think of it as water
under the bridge.
Classical economics says only future
costs and benefits should matter.

(01:06):
But we're not
always rational.
Rational choice theory assumes we
make decisions to maximize utility.
But behavior economics, pioneered by
figures like Kahneman and Traversky,
show we often
deviate from logic.
The term sunk cost originated in
accounting, but its

(01:26):
psychological impact was only
recognized later.
To understand the sunk cost fallacy,
we need to look at our minds.
Loss aversion, the tendency to feel pain,
to feel the pain of loss more than the
pleasure of gaining
something, plays a huge role.
Cognitive dissonance, the discomfort of

(01:48):
holding conflicting beliefs, also derives
us to justify
bad decisions.
Our egos and the need for
self-justification are powerful
motivators.
We want to prove
we are right.
And then there's the escalation of
commitment, where we invest more into
failing projects to try

(02:09):
to turn them around.
And that's a recipe
for disaster.
Prospective theory helps
explain why we chase sunk costs.
We evaluate losses relative
to a reference point.
And the pain of loss
drives our decision.
Studies have shown even trained
professionals fall prey to this bias.

(02:31):
Neuroscience research reveals that
decision-making involving sunk costs
activates brain regions
associated with emotional pain.
The sunk cost fallacy impacts entire
organizations and even government.
Companies clinging on to outdated
models like Blockbuster or Kodak.

(02:52):
Governments continue to fund
failing projects or certain wars.
It even affects how we address climate
change, with industries resisting to
change due to
prior investments.
We stay in jobs or education paths we no
longer believe in, simply because of past
investments.

(03:12):
Letting go of sunk
costs is hard.
We have emotional investments and letting
go feels like cutting a
part of ourselves away.
We're often driven by
the illusion of progress.
Believing that if we just invest a
little more, things will turn around.
The fear of regret and failure is often a

(03:34):
powerful force, but we
can overcome this bias.
By reframing the situation, focusing on
future opportunities
rather than past loss.
By adopting an opportunity costs mindset,
help us see what we could
gain by changing course.
Regular evaluation and

(03:55):
self-awareness are also essential.
And don't underestimate the
value of external advice.
In financial investing, this
fallacy is particularly dangerous.
Investors hold on to losing stocks,
average down, and refuse to sell real
estate for less than
what they paid for.
Venture capitalists continue

(04:17):
funding failing startups.
To avoid this, set clear criteria,
regularly review your portfolio,
and focus on
future potential.
Leaders must be vigilant
about avoiding this trap.
They should evaluate projects regularly,
encourage innovation, and create a culture
that values learning
from mistakes.

(04:38):
Ethical considerations are also crucial,
and leaders should invest in developing
their decision-making
skills.
Thank you for joining us on
this short PocketByte episode.
We hope this episode gave you some
valuable insight into
the sunk cost fallacy.
Remember, financial decisions should be
based on future potential and not past

(04:59):
investments.
Until next time.