A gambler might call it chasing your losses. The British saying – ‘don’t throw good money after bad’ – captures a similar sentiment. Economists call it the sunk cost fallacy, and it’s ubiquitous.
We all do it. Ever gone to the cinema and stayed to the end of a film you actually loathed 10 minutes in – or watched yet another season of what was once your favourite TV show? This is the logic that says “I’ve sunk a lot of money into my old car. I can’t just scrap it now. I really should replace that faulty gearbox”. (See also: those who stay in bad relationships for several additional years because they don’t want their time together to have been ‘all for nothing’).
What links these examples is the phenomenon of continuing to throw good resources (time or money) after bad, hoping for things to improve when there’s no good reason to believe they will.
In other words, people are loath to cut their losses. We are much more likely to continue to senselessly plough time or money into a project that isn’t working out, in the hope that it will get better, than take a hit and walk away. What drives this is optimism (that, against the odds, the situation will improve) and an aversion to failure.
Even animals can show a sunk-cost bias. One recent University of Minnesota study found mice and rats were just as likely as humans to fall foul of lab experiments involving delays and rewards. In each case, the more time invested waiting for their ‘prizes’ (for the rodents, flavoured pellets, for the humans, funny videos) the less likely they were to quit the pursuit before the delay ended. According to some researchers, this pattern may suggest some evolutionary reason for this economically irrational flaw.
‘A winning hand’
At work, the consequences of desperately hanging on to irrecoverable costs can be catastrophic. For smaller firms, this could mean, for instance, putting off firing a worker you have spent months training, even though it was clear from the outset they were never going to cut it.
But this same spirit pushes people towards totally illogical huge investments. Thinking only in terms of future possible gains means they fail to factor in unrecoverable funds already spent. It’s easy to see why.
After you’ve invested £10 million ($13m) in a project, which hasn’t delivered, the case for throwing in a further £5 million is far easier to justify if you only consider returns on £5 million – rather than £15 million. But in reality, of course, you also don’t want to look stupid by abandoning it.
In his book Thinking, Fast and Slow, Nobel laureate Daniel Kahneman hypotheses that ‘sunk cost’ thinking often explains why firms turn to new management, or hire consultants, at this stage of a project’s decline. Not, he believes, because they are necessarily more competent than the original managers – but because the new arrivals carry none of the political baggage (and the associated reluctance to cut losses and move on).
Like a gambler ‘chasing losses’ at a poker table, people stuck in the sunk cost trap will pretend that they have a winning hand. Nick Leeson, the infamous ‘Rogue Trader’ who caused the collapse of Barings Bank in 1995, followed similar reasoning in trying to recover his position from a series of disastrous early trades.