Have you ever started to read a book and midway you realize this book is just not for you? Since you have invested so much of your time reading the book, you just don’t want to skip this book. You think of finishing this book. But why? Even though you no longer like to read any further you keep reading.
Let me get into your perspective- I have invested a lot of my time reading till here and I don’t want to waste those invested time and just skip this book. I would rather keep reading the book even though I know I don’t like it.
IT Field Perspective
Let’s take another example of an IT company. Suppose there is an onsite requirement and your manager has to choose between you and Suresh. Clearly, you’re the experienced one, but the manager chooses Suresh over you. As you know, there are a lot of formalities to be done by the manager regarding Visa, relieving letters, and so on.
For this, a considerable amount of the manager's time and effort is taken. But when Suresh lands in the client’s place, clearly the client isn’t happy with Suresh’s performance. The manager thinks he has specifically chosen the guy, he doesn’t want to disappoint the client either. So, he spends another budget of the company’s money to train Suresh on the domain.
Even after months of training, the client isn’t happy about Suresh. Putting more effort to keep Suresh there, the manager sacrifices more of this time to save his reputation as a manager. But with all the time and effort wasted, Suresh is finally called back to the base location. Take a moment and think about what has happened here. Clearly, there was an emotional attachment to keeping Suresh there.
Even though the manager knew Suresh wasn’t performing enough, he kept him there and upon that invested a lot of money and his time, again and again, to keep him there. The amount of time and money invested by the manager to keep Suresh there onsite is the sunk cost. Even though the manager knew Suresh wasn’t performing enough, he kept on investing his time and money, this is called sunk cost fallacy.
Let me take you to a business perspective. Suppose you have started your own business. It’s been a year running and throughout the year you have invested your time, money, and effort. But the business isn’t going as planned. It isn’t generating any profit and you, on the other hand, are putting your time, energy, and effort to run the business. At all costs, you want to run the business even though at the back of your mind you know it isn’t generating any profit.
There are 2 scenarios here: Hoping that the business will turn around and start generating revenue or the business can go bankrupt and close down. See here, the first option of hope is what most of us do, in doing so we, again and again, invest our time and money hoping one day it might turn around. The invested time and money is the sunk cost and your hope that the business will turn around is the fallacy-Sunk cost fallacy.
Let me give a few more examples related to our day-to-day life:
People spend 10-15 years in a career that is not going anywhere, but people still stick around because they don’t want their past 10-15 years of experience to go in vain.
Suppose you're in a bad relationship for 3 years, but you still want to be around in the hope that things will work out in the future and that you have invested 3 years into this already.
Imagine your going to the store and halfway you realize, “Oh wait, the store is actually closed today”. But you figure I have already come halfway I might as well go all the way to the store to check out so that my halfway of riding wouldn’t have to be wasted.
Suppose you brought a 10,000-rupee plane ticket and a day before you fell sick, really sick in the stomach. Now you’re thinking not to take flight but the ticket isn’t refundable and you have already spent a lot on the ticket. So, you eventually take the flight of 10 miserable hours when you could have just booked another flight a day after.
Let’s say you’re watching a really horrible movie but you are already 30 mins into it and you think you might as well keep watching the movie till the end. You keep watching because you don’t want to feel like those initial 30 mins are put to waste.
Stock Market Scenario
Suppose you have invested in Gitanjali at Rs.80 in 2018 (See above graph). Now it has gone down to 2 rupees. A whopping 98% loss in capital. Now trading around 2 rupees, you think I should buy more shares of Gitanjali in order to bring down my average and hoping the share price to move up. Should I buy again 2 lakh, 3 lakh, or 10 lakh rupee worth of shares? But what you need to focus on here is the idea that what if you were never invested in Gitanjali.
Knowing what you know about the company right now, would you invest in Gitanjali gems? The answer will most probably be NO. but what about the initial losses from my first investment. We need to realize every new rupee put into the stock market is independent of the previous investment.
See my article on Gambler’s fallacy to know more on this. The same is applicable when you’re trading as well. When you’re in a trade and are incurring a heavy loss, instead of thinking about averaging the position by adding more capital to it, think of exiting that bad trade by the first opportunity you get.
What happens here is our brains rationalize the sunk cost and move forward even though we know we wouldn’t get back our invested time and money. Part of the reason why humans do not accept sunk costs is loss aversion.
Loss aversion is a tendency for humans to avoid loss whenever possible because they don’t like it. So, when faced with the possibility of losing sunk cost, our brains naturally want to avoid that as much as possible. The sunk cost fallacy makes it difficult for us to quit something we feel we are too invested in especially since we might think we are losing something because of it.
However, it is better to accept our losses and move on as you will never recover the true value of something once it is gone.
“Life is full of sunk cost; it is best to recognize them and not let them bring you down”