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Tag: loss aversion

Knowing When to Abandon Ship: The Sunk Cost Fallacy at Work

Sinking Ship 

You have invested $10,000 into a hot new energy drink eggnog stock that you heard would take off like Santa’s sleigh.  You’re not sure why, but the stock’s performance hasn’t done what you expected.  In fact, you are down over 20% after the first week.  Your friends are all telling you to sell, but you’ve already invested this much into it and still think that there is a chance that it can rebound – you decide to just stick it out.  Over the next few weeks, the stock tanks, but each day, you keep thinking about the $10,000 that you invested and hope for a rebound to get that money back.  In the end, the company folds and you lose the whole investment.   

This is an extreme case of The Sunk Cost Fallacy.   

Getting Invested 

The Sunk Cost Fallacy is the tendency to continue to invest resources such as time, money, or energy into a decision even when it becomes clear that this decision is not in one’s best interests. When we make a significant investment, it becomes more difficult for us to walk away from it. Past investments heavily influence present and future decisions, regardless of the potential benefits.  

This bias is frequently seen within organizations and the continuance of certain projects that, to an outsider, may seem doomed from the start. For example, a company that continues to pour a substantial amount of time and money into a research project that has failed to produce the expected return. Prior investments can weigh so heavily on the minds of decision-makers that they start to ignore warning signs and continue pouring more into the project to see it through. 

What’s There to Lose? 

A related concept, loss aversion, may contribute to the occurrence of the Sunk Cost Fallacy. For some, the fear of acknowledging a loss can lead to the persistence of a failing project in hopes that a further investment will eventually turn the tide (think about the story at the beginning of this blog).  Humans are often more motivated to avoid a loss than to acquire an equivalent gain, making it difficult to give up on prior investments seen as a loss – particularly if there is even the slightest chance that the loss will not be realized (i.e., that the stock will rebound or that the research will have a miraculous breakthrough).   

Emotional attachments are another factor making it difficult to walk away from investments. Individuals often develop emotional attachments to certain projects or decisions which can cloud their judgment. Making an objective assessment of the current and future state of a project becomes challenging when prior investments that carry an emotional element with them weigh heavily in the decision-maker’s mind.  

For organizational decision-makers, public commitments intensify the sunk cost fallacy. Typically, people would rather not admit to a failure. In some cases, this fear of failure is enough motivation to stay the course regardless of the potential consequences. Managers can fall into this trap especially when they assume their organization places a high value on saving face. When the pressure of maintaining a certain reputation comes into play, managers may choose to continue with a sunk cost despite the red flags popping up in the process. Taking accountability for a mistake may be more daunting than continuing with a failed project.  

The Art of Letting Go 

One of the best ways to combat the sunk cost fallacy is through training. Educating employees on common biases within the workplace and training leaders to prioritize accurate decision-making based on the best potential future outcomes rather than their reputation. Organizations can often avoid any further losses by fostering the right organizational culture. When decision-makers feel comfortable admitting to a sunk cost, further investments into failed projects can be avoided.  

The Lantern Group has worked with organizations for over 25 years training employees and leaders on different behavioral science principles to improve the workplace. If you are interested in improving communication, understanding human motivation, and mitigating biases in your organization, contact us today for more information on how we can partner with your organization.  

Behavioral Economics and Change

brain - left and right

Rational vs Emotional

For the past 20 years, I have been exploring how people change their behavior.  This exploration has led me down many different paths and lines of inquiry.  One of the most fascinating areas of research that I’ve investigated surrounds the now hot topic of behavioral economics.

I often describe behavioral economics as the “fusion of psychology and economics in order to gain a better understanding of human behavior and decision making.”

So what do we find out when we fuse psychology and economics together?

“Humans often act in very irrational ways.”

Now that is not ground breaking news for most of us.  Even when I graduated with an economics degree, I knew that people didn’t always act in rational ways – or at least I didn’t  (otherwise why would I stay up watching bad T.V. until 2:30 AM when I knew I had to get up by 7:00 AM for a meeting or why would I spend a hundred dollars on a dinner out but fret over buying a steak that was over $10 at the grocery store?).

However, for many economists, that statement was hearsay.  Many economic models are based on the fact that people act in rational ways to maximize their own utility (i.e.,  happiness).  These theories stated that we might make irrational choices in the short-term, or when we don’t have enough information, or that at least your irrational behavior would be vastly different than mine so that on average, we would be rational.

The truth discovered by behavioral economics is that is not often the case.  We don’t act rationally – in fact, we sometimes act exactly opposite of how an economist would think we should act.

For example, research has shown that we will judge the value of an unknown item using totally irrelevant data to help us in that decision.  Dan Ariely ran a wonderful study where he asked people to bid on a wireless keyboard (something that they were not very familiar with at the time), but before they answered, they had to write down the last two digits of their social security number (a totally irrelevant piece of data).   The results of the bid were fascinating (top 20% being SSN that ended in 80 or above, the bottom 20% being SSN that ended in 20 or below):

Anchoring results

This is a significant difference in how much they bid – entirely based on the last two digits of the SSN.

Here’s another one.

Would you work harder for a set amount (say $10) or for an uncertain amount (say 50% chance of $10 or 50% chance of $5)?  Most rational people would say that they would work harder for the guaranteed payout of $10…that isn’t the case.

In a study that looked at drinking a large amount of water in two minutes – some people were offered a $2 fixed amount for finishing it – the other group was told they would earn either $1 or $2 (random chance of either).  So what was the result?

Behavioral Econ Uncertainty

43% completion rate for the certain award versus 70% completion rate for the variable?  Not what you would think right?

Note – that this doesn’t apply to people choosing to participate – existing research suggests that we prefer certainty over uncertainty when deciding if we should opt-in for a goal.  However, uncertainty is more powerful in boosting motivation en-route to a goal.

So what does any of this have to do with change?

We so often want to drive change in ourselves or our organizations and think through the process of this – in a rational and systematic manner.  I’ve worked with companies who are baffled that they don’t see a long-term increase in employee productivity and satisfaction after they increase their wage (Hedonic Treadmill Effect).  I know people who have mapped out their exercise routine for the next day, only to hit the snooze button instead of getting up and going for their morning run (Hyperbolic Discounting).

Too often we try to implement a change program based on a belief that we are rational beings.

Behavioral economics highlights that this just isn’t the case.

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