Sunk Costs: In War and Peace and Markets

Defenders of Berlin were jolted into motion as a terrible thunder shook everything around on a cold, wet winter morning. At 3 am on 16th April, 1945 the Soviet army had started a barrage of bombardment at Nazi Germany’s final fortifications at Seelow Heights with heavy artillery, in the final assault on Hitler’s Wehrmacht – the German army –  in what came to be known as the battle of Berlin towards the end of World War II. It ended up as one of bloodiest battles in history with more than half a million casualties. It was also a battle where the outcome was largely known beforehand. Even before the battle began, the Wehrmacht, or what was left of it after six years of debilitating war, did not stand any chance in the face of the fierce Soviet war machinery and the red army’s vast superiority in men and resources. Any other conclusion to the WWII would not have seemed plausible that morning to even the staunchest of Nazis.

Then what would have made the Wehrmacht agree to fight a battle that was lost at best, and to take the risk of massive casualties, instead of laying down the arms? More surprisingly why would the German civilians have participated in the defense of Berlin even if it increased the risk of gory retribution at the hands of the red army after the battle?

Fast forward to more recent past. A friend (‘ A’) received a free pass for a play for which another friend (‘ B’) had purchased a ticket for Rs 1,600 for the same show. Unfortunately it turned out to be a rainy day with incessant rains and water logging. ‘ A ‘ decided not to go for the play considering the risks involved in venturing out. However ‘ B ‘ said he would brave the rains and flooded roads, and attempt to drive to the theatre.

Now, what would have led to the difference in behaviors of ‘A’ and ‘B’?

Genesis: Past is present

Both the above instances are examples of sunk cost fallacy. The Germans and ‘B’ – both ignored the economic maxim of sunk costs. As per economic theory, the price paid should not affect our choice since it has already been paid. It cannot be returned and hence is sunk cost. The rational decision for Germany would have been ceasefire- forgetting the lives and resources lost in the war till then, to prevent further destruction of the country and to limit atrocities on civilians that often follow a bloody end to a hard fought battle. For ‘ B’ the rational choice would have been to stay at home – forgetting the money gone towards purchasing the ticket, to avoid any accident or illness that was possible in stepping out on a rainy day.

Such decision points are encountered quite often – continuing to hold a stock with poor prospects, sad marriage, rudderless project at a company, bad job, bleak research project, continuing to wear badly fitting shoes. Sunk cost fallacy hinders rational decision making in such situations and causes unfavorable outcomes. For econs – the rational humans – sunk costs do not matter and they rightly treat sunk costs as irrelevant and hence are able to take better decisions. For normal humans however, sunk costs last longer in mind.

So, why do people think that continuing with a course of action is worth it instead of cutting losses?  Typically when we humans make a purchase at a price that does not produce any transactional utility (i.e. utility of the product, minus what we expect to pay) we do not feel the purchase price as a loss. We have paid some money and are hoping to get the pleasure of acquisition utility ( i.e. utility of the product, minus the opportunity cost) when we consume the product, so that mental account will be cleared. The earlier cost of purchase is wiped out by the later gain in our mental account at the time of consumption.

However what happens when we buy the ticket and skip the event? Paying 1,600 for a ticket for a play that one doesn’t attend feels like losing 1,600. In this case we are forced to “recognize the loss” in the mental books that we are keeping. On the other hand, the more we use something that we have paid for, the better we feel about the transaction.

To put it another way, we tend to view the price paid for a product as an investment (instead of sunk cost) and hence continue to consume it without considering the incremental cost involved. Example – time sharing vacation, membership fee at a club or a shopping chain etc.
In equity markets: Selling the flowers, keeping the thorns?

This afflicts equity investors in a related way – the disposition affect, a form of sunk cost. When there is need of cash, the investor has to decide on which stock’s holding should be trimmed. The untrained human mind often forces a decision on the basis of stocks’ trailing performance. As a result stocks that have performed well so far are the ones that tend to be sold. This helps in closing our mental account in the positive zone. It adds to our sense of self esteem, and of our expertise as an investor. Obviously this process is flawed. The stock to be sold should be decided on the basis of relative prospects -as visible at that point in time.

How to avoid: Look ahead in life

To avoid sunk cost fallacy an active, engaged and disciplined mind is required in the situation. One needs to consider the counter-factual possibilities to think like an econ. Would Germany have fought such a one sided battle with such high risks to civilian areas in the beginning of the war in 1939 – when the WWII had begun, instead of in 1945? Would  ‘ B ‘ have braved rains if he had received the tickets free of cost? Would a CEO have continued to invest in a mining project facing insurmountable environmental hurdles if he had not pumped in Rs 100 crore in it till the decision point? The key is to close mental account when the cost is incurred, and to look at future prospects instead of keeping the past alive.