Sunk Costs

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Sunk Costs

A factor driving loss aversion is the sunk cost fallacy. This theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

Things To Know

  • Sunk costs are a big reason we hold onto losing investments.

Consider the theater as an example

One example of this would be if we purchased expensive theater tickets only to learn prior to attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us by a friend. Rational behavior would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible, we would choose to go or not go based on our interest. Instead, our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits. Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses. Had the dropping stock been a gift, perhaps we wouldn’t hang on quite so long.