Behavioural Finance: Loss Aversion and Sunk Cost Fallacy

Have you even gone to a buffet lunch/dinner, found out that the food was very bad, but ended up eating your fill anyway?
Or unknowingly bought an uncomfortable pair of shoes and kept wearing it even though it was painful?
Did you ever sit through the most boring movie of your life, because you spent money for the ticket?

I know most of us have had experienced something similar and we all have been victims of the Sunk Cost Fallacy. Sunk cost is a retrospective or past cost that is been made into a business or decision. But before we try to understand sunk cost fallacy lets see something called “Loss Aversion”.

Loss Aversion

Loss Aversion is the strong tendency that people have that makes them to avoid incurring any loss. We are more wired to avoid losses than to acquire gains. The amount of loss doesn’t matter, it is the feeling of losing something that counts.

There was an interesting experiment done by the Behavioural Economist Dan Ariely who setup two booths where people could buy chocolates. There were two kinds of chocolates – Hershey’s Kisses and Lindt Truffles.

  • In shop 1, Kisses cost 1 cent and Truffles cost 15 cents, which is the usual price you could buy them elsewhere.
  • In another shop 2 (setup a bit far away from shop 1), the price of both chocolates was reduced by 1 cent – so Kisses was given free and Truffles cost 14 cents.

In the ideal world, there would be no difference to the number of chocolates sold in both the shops, as the difference between two chocolates is always 14 cents. But in the real world, there was a very notable difference. In Shop 1 (where both chocolates cost some money), people preferred buying Lindt Truffles as it was a better chocolate and they wanted to enjoy it. In Shop 2 (where Kisses was given away for free), more people picked kisses than they bought the Truffles.

The reason was, people’s Loss Aversion instincts kicked in. They saw that a chocolate which usually costs 1 cent is now free and they would be a fool to not accept that offer. In other words, they thought that they are losing money because they didn’t pick the free chocolate.

This is the reason, many shops entice their customers with free gifts, free shipping, unbelievable offers, etc. When you want to buy a gadget from two competing stores, you would be willing to pay even a few hundred rupees extra if one of the shops offered a freebie with the product – because your loss aversion instincts kicks in.

Sunk Cost Fallacy

This loss aversion instinct is what leads us into Sunk Cost Fallacy. A Sunk Cost is money or time you have investing in a project or investment already and which cannot be recovered.

Lets say you wanted to surprise your spouse and bought tickets for your summer vacation and have already spent Rs.10000 for the travel and stay. Your spouse wanted to do the same and planned a vacation to a different place and spent Rs.5000 for the tickets and stay. Finally you both find out that the dates are overlapping and the travel agent says that the money is non-refundable. Which trip would you go with? When a bunch of people were asked in a study, more people chose the costlier trip.

If you think about the reason, it is quite simple. Both the money spent is a sunk cost (money that cannot be recovered). Since you can go to only one trip, you wanted to minimise your losses. You thought that losing Rs.5000 is much better than losing Rs.10000, even though you might have enjoyed the cheaper trip. This sunk cost fallacy makes us do all sorts of stupid mistakes without even realising it. Even big governments with numerous experts and economists are prone to this – which is why they keep building many projects which are not financially profitable.

Personal Finance and Sunk Cost Fallacy

Now how does this fallacy affect us in personal finance and investing?

  • We all know Term Insurance is the best insurance than the traditional Endowment/Money Back Policies or even ULIPs. But we would have taken a few traditional insurance policies and we keep paying more money in it, even though we know the returns will be less than 6%. Because we have already invested for 3-4 years and its a sunk cost. Surrendering the policy means getting out at a loss. So we keep paying for these useless policies (including me).
  • We would have invested in many stocks and in a bear market when everything falls down, we would still be thinking “No No. These stocks are good and it will come back up at least to the cost price. After investing so much in it, selling now will be a loss.” This is even more dangerous if the stock is falling because of a fundamental problem and the investor thinks “The prices look so cheap. Let me buy more and average my price.” Just because we invested money in a stock we shouldn’t expect it to rise. Worst cases, it is better to book losses and shift that money to a different stock to get back your capital.
  • When it comes to Personal Finance, people spend more money repairing old appliances like washing machines, water purifiers or even their first car. In most cases, it would be cheaper to replace the unit instead of trying to repair it and source spare parts for it. I am not saying you should throw it out at the first sign of repairs. But when you keep trying to repair something which is older than you can remember – not worth the money.

How to avoid it?

  • If an investment doesn’t go the way you thought, admit you made a mistake. Cut your losses and exit. Try to preserve the capital, so that can be invested in a better opportunity elsewhere. You can recoup the losses and even make a better profit.
  • Check for opportunity costs. Instead of keeping your money in bad investments, switch it over to better investments.
  • And as with other fallacies or biases, try to be as rational as possible, think critically, analyse and evaluate before you make any decision.

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