What Is Sunk Cost?

Although unprofitable investments are a concern, the unrecoverable costs have proven to be the true financial concern. These sunk costs depict the permanent loss of invested capital or resources. Similar to the sunk ship Titanic, sunk costs cannot be retrieved. Navigating through the complex terrain of the share market, investors frequently encounter sunk costs. 

Understanding this concept and learning how to avoid them is crucial, as sunk costs can have a significant psychological impact on investors and their decision-making. Let us understand the sunk cost definition, look at some examples of sunk costs and learn how to avoid them.

Sunk Cost Definition

Sunk costs are defined as non-recoverable costs. These costs arise when a particular commodity swallows the resources allotted to it, making those resources non-transferable. Majorly, sunk costs are considered to be fixed costs.

These costs are not considered for future or budget-related decision-making as they have a negligible impact on the outcome. This can be primarily because for making a future related decision, only the relevant costs that can be modified are considered. Since sunk costs have already been incurred and cannot be modified, they are not considered.

Examples of Sunk Costs

Sunk costs can occur in different aspects of our lives, such as:

• Market investments

A person purchases company shares and is reluctant to sell it, even though the company has weak fundamentals. Over time, the company goes bankrupt, dissolves and share prices are nil. The resources invested in the company share are not irrecoverable. The funds lost in these investments would be termed sunk costs.

• Personal investments

A person purchases a gym membership for a year due to the new year’s resolution of healthy habits. However, a few days later, the person stops going to the gym even though the payment for the whole year has been made. The gym membership cost, being unretrievable, can be an example of a sunk cost here.

What Is the Sunk Cost Fallacy?

The sunk cost fallacy is a mindset a company or individual may have when making an investment decision. This mindset arises when the person believes the current plan needs to be followed as the resources have been committed. 

The misconception arises because the company or individual refuses to accept the present and trusts intuition instead of making data-backed decisions.

For example, when a company share is bought, and the company fundamentals start to weaken over time, it is depicted in the share price. A person entangled in the sunk cost fallacy will not sell the share when he has the opportunity, believing that since investment has already been made, deviation is not an option. This may result in losing almost every buck invested in the company.

This fallacy arises in business when, despite changing circumstances, the management refuses to deviate from the original plan. When investment decisions are affected by emotions, it can make a person prone to the sunk cost fallacy.

Factors That Lead to the Sunk Cost Fallacy

1. Loss aversion: People generally focus on avoiding loss rather than making a profit on their investments.
2. Blame game: The loss that arises from the decision-making is blamed on the individual making it, instead of the data or circumstances.
3. Attachment: An individual may feel emotionally attached to the investment made which creates an emotional bias resulting in biased decision making.
4. Overt Optimism: The blind faith in an investment that the circumstances will change for the better purely based on the attachment.
5. No backup plan: People may stick to a plan because it is the original plan, and the resources do not have an alternative project where they are allotted or transferred.
6. Lock-in-period: Many projects or investments lock the resources for a specific period of time. Over this time, the resources allocated become non-transferable and have no other choice but to bear the consequences.

How To Avoid the Sunk Cost Fallacy?

By thoughtful planning and committing to data-driven decision-making, an individual can avoid the sunk cost fallacy. Some other ways are as follows:

• Define your objectives before investing in a project or asset and thoroughly analyse all available options.
• Be aware of the investment’s lock-in period and consider all the external factors that can affect the resources.
• Prioritise your investments/projects periodically. Are they in line with your goals? Not all projects are equally created. Invest accordingly.
• Accept the unknown – uncertainty and change with grace. This will help you to explore the opportunities available.
• Feed your attention to the future. Dwelling on the past will add an emotional bias to your decisions. Instead, focusing on the future can help you be more flexible in your decision-making. Always see the bigger picture.
• Make decisions based on objective analysis rather than personal attachment to past investments or decisions.
• Define the problem, understand the situation and determine what is important for you and what is unimportant.
• Make decisions based on data and not on emotions or intuition. Always be detached from your investments.
• Don’t let the sunk cost steer you away from the goal. Keep navigating without letting them navigate your future.
• Be open to adjusting your risk tolerance and consider taking calculated risks to move forward.

In the End

Investing always involves the boon of reward and the curse of risk. Balancing the two factors is how you allocate your resources effectively to align with your goals. Hopefully, this blog will help you avoid the sunk cost fallacy. So, the next time you encounter sunk costs, keep your sights on the bigger picture and forge ahead confidently.

To take your financial journey to the next level and explore investment opportunities with Angel One, open a demat account today and invest confidently. Feel free to come back to this blog whenever needed. See you at Angel One!

FAQs