Economic Investment – Sunk Costs & Loss Aversions

We reserve the right to change our minds especially as new information presents itself but why don’t we?

A few reasons…

Sunk costs, loss aversion, reputational hit, etc

First let’s explore these in greater detail.

Sunk cost – once we make an investment or spend money, time, resources, etc we feel like we have a stake in that project or item so we get attached. We do not want to lose our investment and even if we have a greater chance of losing more, our confirmation bias overrides our rationality and convinces us that if we hold on a little longer we will be better off. However, we usually know in our gut that it may not be in our best interest.

This leads us to the next point – loss aversion. Yes, we have an aversion to losing especially once we “feel” we have something. Yes, it is that “feeling” of owning or having something and as humans we dislike losing it – usually, not everyone as there are always exceptions. Some good examples are test driving a car, champagne “time share” vacations, free trials, etc. This is why businesses give stuff away for free. They utilize excellent marketing research and psychological studies as well as understand behavioral economics on how humans decide with heuristics and biases and predictable violations of choice axioms. They know that if they give their “stuff” away for free then it is easier to sell afterwards. People do not like to “lose” it. Free trials can be very effective especially if the product is very good.

We have heard of politicians “flip flopping” and we tend to hold them to their word which seems to always be changing. This is an example of a reputational hit. However, changing your mind can be good especially as new information presents itself. It may be necessary to avoid major consequences.

Others see it as being a quitter. We need a culture change.

I always say I never give up except for a few things:

Trying to please everyone.

Fearing change.

Living in the past.

Putting yourself down.

Overthinking.

And also reserve the right to change your mind.

Solutions? Here are a few ways to overcome these BIASES.

Counterfactual thought experiment: Would I do it if NOT prior invested?

Bring in non-stakeholder and give them NO information of sunk cost and ask their input.

Focus on quality of decision process more than decision outcome.

Always perform expected value calculation. I use EV extensively to estimate the worthiness of investments, often in relation to their relative riskiness. It is always about the risk. Risk adjusted returns are key (that is an entire discussion in itself)

What is EV = probability1 * value1 + probability2 * value2 * … that is how you derive at your expected value.

Some examples of business decisions that may benefit from these 3 questions above:

A hired person you have had working for you but it has not been working lately. Yes, instead of making a binary choice on whether to keep them or fire them there are other options such as restructuring or modifying their duties or roles but let’s say you have already exhausted those options and must decide whether to keep them at your business. Many people are more reluctant to fire that worker that is not working out due to sunk costs. Yes turnover costs are costly but retaining a worker that isn’t contributing to the business in an effective or efficient way can be even costlier. Ask yourself, would I hire this person now if I knew what I know now?

*TIP: Pre-commit to de-escalate if results don’t align with preset performance criteria.

This is similar to stop losses in trading. You pre-commit to selling your trade if it goes against you. It should always be established BEFORE you enter the trade otherwise your emotions can arise and cause you to act impulsively. Remember it is not about eliminating emotions but reducing your reactions and responses from them. Journaling is great to help you keep track of your feelings and learn from your emotions. Your emotions are good and provide you with valuable insight about yourself. Learn from them just minimize your reactions based on them. Changing our minds during a trade does not apply here because the precondition above is: Pre-committing to de-escalating. Once the trade is executed, we get emotional and usually do not remain rational about it so we follow our trade plan.

Fail early, fail often and learn from your mistakes. However, do not let these mistakes, sunk costs, etc coupled with your aversion to loss cause you to keep throwing good after bad. Reserve the right to change your mind especially as new information is presented.

Always remain flexible and open minded.