Despite being one of the most basic ideas of microeconomics, “sunk costs” are deceptively easy to understand; yet, they lead even the most rational people to make irrational decisions. The basic idea of a sunk cost is quite simple: once a cost has been incurred, it should have no bearing on future decisions (it is “sunk”). The classic example of this phenomenon is the advance purchase of a movie ticket for which one cannot receive a refund. Once the purchase has been made, and the date of the event has arrived, the ticket holder must decide whether or not to attend the event. If attending the movie provides more utility (a measurement that describes one’s satisfaction from the consumption of goods or services) than not attending (and spending the time doing something else), he should attend. If skipping the movie provides more utility he should not attend, and use his time differently; this is also known as “opportunity cost.” Furthermore, this example embodies sunk costs, as the price of the ticket should have no effect on whether he should go or not, since it cannot be recovered.
However, it should be understood that sunk costs are not the same thing as prospective costs, which are costs that may be incurred in the future, dependent on a decision. A sunk cost is irretrievable — once incurred, it cannot be recovered — but a prospective cost can be avoided, and therefore should be considered when making a decision. However, prospective costs may be worthwhile — the ticketed event may be a more valuable investment than its upfront cost — and it is therefore perfectly rational to decide to pay it. Once the decision has been made, however, the prospective cost becomes a sunk cost, and should not influence any future decisional outcomes.
Despite its apparent obviousness and rationality, people frequently fall prone to irrationality when dealing with sunk costs. The “sunk cost fallacy” leads many people to make irrational decisions — such as attending the event in the earlier example, even if the utility of doing so does not outweigh the opportunity cost (of not attending). This is often explained as a type of loss aversion, a way to avoid feeling as though we have “wasted” what we have already paid.
Such irrational behavior, however, can have serious consequences, especially when dealing with business or investing. Surprisingly, companies are just as prone to the sunk cost fallacy as individuals, but often on a much greater scale. Too regularly, companies throw good money after bad — continuing to fund projects or research that are unlikely to pay off, if for no other reason than that the company has already put a great deal of money towards its success. Such decisions can be disastrously costly for companies, and should be avoided.
The sunk cost fallacy can be equally harmful when making individual investment decisions. Whether experienced hedge fund managers or beginners, investors are people, and are thus prone to making irrational decisions. Sunk costs can include transaction costs, such as brokerage fees (commissions) and losses: the sunk cost fallacy can often allow losses incurred in a particular investment to influence future decisions concerning that investment, such as whether to sell or double down, and can be extremely costly in the long run.
Like many of our biases and heuristics, sunk costs often lead us to make irrational decisions, many of which can be quite expensive when investing. While some economists have attempted to explain the irrationality of the sunk cost fallacy in terms of personal utility and our happiness of avoiding waste or loss, such explanations cannot justify bad investment decisions, which can be measured purely in financial terms. However, by recognizing the existence of the sunk cost fallacy, it can easily be avoided, allowing us to make more rational decisions when investing.