Monday Mornings with Madison

Decision-Making and the Sunk Cost Fallacy, Part 2

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Estimated Read Time: 8 min.

It is natural for a person to not want to lose something into which he/she has invested time, money, energy or emotions.  So the person devotes even more resources toward making the investment work, even when it is a bad decision.  That’s the Sunk Cost Effect.  On the one hand, self-protecting from a loss is a natural instinct and a valuable one for survival.  Some things do require just a bit more time, effort or support in order to turn a questionable decision or direction into a brilliant one.  After all, it took Amazon seven years just to break even and today is showing $60 Billion in annual revenue.

On the other hand, it can also be detrimental to not recognize miscalculations and instead continue with a bad decision.   Leaders that have continued to invest in bad decisions have sunk companies, in part because of the Sunk Cost Fallacy.  Indeed, the Sunk Cost Fallacy is particularly evident in business decisions because the risk of loss and gain is tied to job performance, judgment and success.  There is a lot of pressure to demonstrate sound decision-making ability in leadership.  That explains why so many leaders double down on bad decisions.

A Common Cognitive Distortion

Christopher Olivola, an Assistant Professor of Marketing at Carnegie Mellon’s Tepper School of Business, conducted a series of eight experiments on the Sunk Cost phenomena in 2018.  The results were published in Psychological Science journal.  According to Olivola, “The Sunk Cost Effect is the general tendency for people to continue an endeavor, or continue consuming or pursuing an option, simply because they’ve invested time or money or some resource in it.”[1] What is most interesting is that not only does the sunk-cost effect happen in intrapersonal situations – such as decisions driven by a person’s own past investments — but it also happens in interpersonal situations.  That means people will alter their choices in response to other peoples’ past investments.  (Who says people don’t learn from someone else’s mistakes?)

Experimenting with diverse scenarios, Olivola found that the sunk-cost effect occurred even when the costs were borne by someone other than the decision-maker and even if the other person was not someone who was socially close and even if no one else knew that the person was reinforcing a past decision.  What was clear to Olivola is that the Sunk Cost Fallacy — a significant and irrational thinking error — is more commonplace than previously believed.  In business, that is not good.

The Sunk Cost Effect applies to all kinds of decisions.  It happens in everything from education to career choices.  A common example is the decision to pursue an MBA just because the person already earned a degree in Business and that is the next logical step.  The person may not even like working in that career, and it makes no sense to sink even more money into an advanced degree in a field that is not appealing.  However, having already invested $80,000 into a Bachelor’s degree and having five years of experience in management, it is not unusual for a person to double down on that decision by investing even more money into a unappealing career path.

Of course, the Sunk Cost Effect applies to a myriad of decisions business leaders must make on a daily basis.   The more confident and self-assured a manager is or needs to appear, the more likely that person will escalate a prior commitment due to the time and money invested.  In doing so, the manager is digging him/herself and the organization into an ever deeper hole.   While it is natural to want to get one’s money’s worth out of a purchase or investment, if investing further won’t improve the outcome, then doubling down on the bad decision is unwise.

Most people think they are not vulnerable to the Sunk Cost Effect in their own decisions.  If the research is not convincing enough, consider this.  Most casinos in Las Vegas dedicate a huge amount of floor space inside their valuable lobby space to slot machines… those brightly lit, noisy machines that allow people to bet on whether they will connect three or five elements in a row.  The basic idea behind slot machines is that they “pay out” periodically… meaning each machine will register a win and pay the player some money every so often.  So, people will play a specific machine for hours on end believing that if it hasn’t paid out in a long time, it is overdue to deliver a jackpot.  The longer the person sits there and puts money in a particular slot machine, the more invested they feel and less likely they are to walk away.  The thought process, however, is flawed because the pay out process is random.  When a person last hit a jackpot on a particular machine is irrelevant.  The more a specific machine is played does not affect when it will deliver another jackpot.   And, yet, slot machines are incredibly popular.  In fact, “80% of revenue in Las Vegas comes from individual encounters with slot machines rather than social forms of play/gambling around a table,” according to MIT Anthropologist Natasha Dow Schull’s 2013 book titled Addiction by Design.[2] That shows the power of the sunk cost thinking error.

Here is an even simpler example to understand the concept and why it is so prevalent.  A person buys a gallon of milk with the idea that she will consume the entire gallon, or at least most of it.   The milk expires.  A week later, the person wants to drink a glass of milk but it has spoiled.  Should the person drink the milk anyway because she wants to get her money’s worth?  Of course, the answer is no.  But, that is what the Sunk Cost Effect amounts to.  The person has sunk money into the purchase and did not get his money’s worth, so he is going to persist with that decision even when it is clear that this is no longer a viable choice.    The problem is that most bad decisions aren’t as easy to spot as a spoiled gallon of milk.

How to Recognize Bad Decisions

So how does a business owner or manager keep from falling prey to this insidious thinking error? On the one hand, throwing more money at a losing investment, strategy, business idea or decision in the futile hope of justifying past money, time or effort spent can lead to bigger losses.  On the other hand, there is no way to lead a company without taking risks.  The key is to not become so indifferent to losses that it leads to excessive risk, or become so cautious about past losses that the cost sunk effect becomes an albatross around your neck.  The goal, then, is to judge decisions based on their future usefulness or prospect of delivering the desired return, not on past feelings about the decisions.  But, how?  That is a tricky balancing act, indeed.  It is the reason why CEOs are paid the big bucks to make such decisions, and why so many of them make flawed decisions and then invest even more.

Here are seven tips for how to avoid the Sunk Cost Fallacy.

1. Keep an eye on the big picture.

It helps to start with a vision and make decisions based solely on that.  Communicate the vision in a detailed way, and have it where it can be referenced often.  For example, if the goal is to launch a new business, write a business plan of what that business will provide and how it will function.  Create the brand for the business so that the identity is well-defined.  Define a Minimum Viable Product with which to go to market as soon as possible.   Discuss the vision, not just the tasks, with others on the team.  Doing these things will help an entrepreneur act with more clarity so that decisions are based on the vision rather than the sunk cost.  It will also help give more thought to decisions made.  The idea is to avoid making daily decisions based only on the present without looking at what makes the most sense down the road.  Case in point.  Jeff Bezos’ vision for Amazon was not to sell books on behalf of Borders, but to sell everything to everyone online… a giant online marketplace.  For a long time, he reinvested all profits back into the business in order to continue moving swiftly toward his vision.  His vision is what drove his decision-making.

2. Embrace creative tension.

Creative tension is a lot like the pressure felt when pulling a rubber band in opposite directions.  People don’t like creative tension and usually work hard to resolve that tension.  (That is why managers tend to hire people who think, act and look a lot like them, instead of looking for people who will push back and challenge their vision.)  But, one way to have creative tension is in describing a vision and then also describing the current reality, in order to clearly demonstrate the gap between the two. This gap leads to both energetic and motivational tensions that beg to be resolved.  In business, leaders can use that as a form of checks and balances by embracing the creative tension between opposing advisers who are offering different ways to resolve the distance between a goal and reality.

3. Keep track of investments.

It is important not to fully outsource anything that requires a big investment of time, money, or energy.  Only by personally crunching the numbers, or at least being aware of them, is it possible to know when the numbers don’t look good and it is time to cut losses.  Seeing those figures firsthand is much more real than having someone else describe it.

4.  Get an outside, objective second opinion.

It helps to get a second opinion on big decisions if there is still uncertainty on whether it is time to cut losses.  A totally objective opinion can provide distance and clarity in a murky situation.

5.  Always consider alternative choices.

At first, it might not be clear whether it is time to throw in the towel on a direction, decision or strategy. Then, over time, it starts to become more obvious that things are not going as planned.  At that point, instead of moving on, it might be tempting to continue on the same path because so much has been invested already.  Instead, focus on what there is to gain rather than what will be lost by changing course.  With a company that is losing money, rather than continuing to throw good money after bad, focus on what else that money could be used to do.  When visions are considered as potential gains, mistakes and losses incurred during the process are tolerated more easily.  But, if those same goals are viewed as what could be lost if success is not achieved, then continuing on the wrong track becomes harder.

6. Focus on the facts.

In deciding if something is a lost cause or a worthwhile endeavor, consider only the facts.  Not opinions.  Not emotions.  Not other people who may be hurt or disappointed with a decision to change course.  Not dreams of what might be.  Analyze what is absolutely known and certain; not what could be.

7. Accept that sometimes things don’t work out.

Part of Sunk Cost Fallacy has to do with avoiding the embarrassment or shame of admitting that an original decision was unwise.  It is important to let go not just of the loss, but also the shame.  Let go of a fear of waste and failure.  It helps to realize that everything in this world grows and changes.  Not all decisions are wise.  Not all projects succeed.  Not all companies survive.  Acceptance of these truths helps to ease the grip on a path that is doomed.

By realizing that decision-making is a human endeavor that is never perfect, it is easier to be able to recognize and accept when a decision or direction is wrong, and it is time to change course.  Who knows… maybe the decision to undo a past bad decision becomes the best decision ever.

Quote of the Week

“It is the characteristic excellence of the strong man that he can bring momentous issues to the fore and make a decision about them. The weak are always forced to decide between alternatives they have not chosen themselves.” Dietrich Bonhoeffer

[1] July 1, 2018, Olivola, Christopher, Tepper School of Business, Carnegie Mellon University, The Interpersonal Sunk Cost Effect, Journal of Psychological Science, Volume: 29, Issue: 7, Pgs. 1072-1083.

[2] September, 2012, Dr. Natasha Dow Schull, Addition by Design:  Machine Gambling in Las Vegas, Princeton University Press, Winner, Sharon Stephens Prize, American Ethnological Association, and Honorable mention, Gregory Bateson Prize, Society of Cultural Anthropology.

© 2019, Written by Keren Peters-Atkinson, CMO, Madison Commercial Real Estate Services. All rights reserved.

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