Sunk Cost Fallacy and Organizational Decision-Making

The captain goes down with the ship, and we go down with our investments.

You know a bias really matters when it gets its own saying. "Throwing good money after bad," only became cliché because people kept doing it. And whenever lots of people keep making the same mistake, something's up.

That something is Sunk Cost Fallacy, which describes the tendency to stick with a strategy because it's what we are already doing, rather than because it is still the best choice (given all available information). In other words, even when a project or investment is an obvious loser, we have a tendency to continue investing in it, in the hopes that we can somehow turn it around, or will eventually be proven right.

But money is just the easiest thing to measure. The same thing happens with time and effort, which explains why people stay in relationships they can't fix. And to make matters worse, the greater the past investment, the more powerful the pull for continued investment.

Perhaps more than any other sphere, the consequences of Sunk Cost Fallacy in the world of business are felt most acutely. And yet efforts to manage it proactively are rare. One familiar artifact of Sunk Cost Fallacy is that it often requires new management to come in and shut failing projects down. Yet for the individuals and teams behind those projects, the prospects of unwinding are so unappealing that even the pretense of objective analysis was long discarded.

What makes us hang on when every piece of objective information tells us to let go? Were we perfectly rational, we would shut projects down or cash out losing investments as soon as there was sufficient evidence to do so.

Instead, we cost ourselves far more time, effort and money than clear thinking would allow. And when we add in the complexities of organizational dynamics and group decision-making, Sunk Cost Fallacy can lead to Sunk Job Reality.

There are steps we can take to avoid this well-understood problem. Yet we hardly ever do. What's behind this behavior, and our resistance to addressing it, individually and organizationally?

As with all cases of systemic irrationality, the answer lies in biases, heuristics and behavioral science.

The Brain's Limitations

The human brain has enough mental energy to process only a tiny fraction of the information available to it. Were people to try to think through every decision, they would become mentally depleted, and effectively paralyzed, by breakfast.

To compensate, human beings have adopted what Daniel Kahneman calls The Dual Systems Theory. Kahneman suggests that people engage in two very different types of thinking: System 1, which is fast, easy and unconscious, and System 2, which is slow, difficult and effortful.

By necessity, we spend the overwhelming amount of our time engaging in System 1 thinking (estimates typically reach 90% and above), reserving System 2 thinking for the relatively rare moments in the day in which we really need it.

If people are spending 90% of their time in unconscious autopilot, it begs another question: who's flying the plane? The answer to that is, "Biases and heuristics," the foundations of behavioral science.

Biases and Heuristics

Biases are mental tendencies, and heuristics are mental shortcuts that help us make decisions without expending mental energy. They fly the plane while we are in autopilot.

Fittingly, people have a bias against the word "bias," because they conflate it with racism, sexism, ageism, and all of the other isms that are worthy of our scorn.

Biases, however, are neither good nor bad. I have a positive bias for people who wear Canvas Chuck Taylor sneakers. As soon as I see them, I feel as though we have shared values and feel a kinship. It's just a mental tendency that helps me avoid spending any of my precious System 2 thinking.

Of course, bias can lead to all sorts of awful problems, especially when we perceive threats where there are none. But the answer is not to eliminate bias, because that is impossible. We could not survive without relying on biases. The challenge is learning how to recognize and mitigate the biases that our rational minds can understand are dangerous.

Heuristics face no such stigma, but play just as big a role in flying the plane in autopilot. Heuristics are mental shortcuts on which we rely when pressed to make decisions we can't "afford" to think through. The affect heuristic describes how we rely on emotions, or "our gut," to make decisions, rather than an extended thought process. Anchoring describes how we hold onto the first piece of information as our reference point in negotiations, without re-evaluating for accuracy or relevance. And availability heuristic describes how ease of recall affects our perception of probability, explaining why people are more afraid of flying than driving, despite the data proving the exact opposite. Plane crashes get a lot more attention than car crashes, so people unconsciously believe they happen more often.

So, what is the cognitive purpose of Sunk Cost Fallacy? The same as every other bias or heuristic: to save mental energy. On the positive side, they help ensure we don't spend our entire weekly paycheck on a Saturday night.

The Emotional Purpose of Sunk Cost Fallacy

Understanding biases and heuristics as a means of saving mental energy is extremely helpful, but hardly tells the entire story. Because they serve our emotional needs as well.

At the heart of Sunk Cost Fallacy is an unwillingness to accept a loss.

That people would be unwilling to accept a loss is hardly surprising. "Loss Aversion" which was first introduce with "Prospect Theory," demonstrates the tendency to be twice as motivated to avoid losses as to secure gains. Losses are so unappealing that to match the emotional equivalent of losing $20, you'd have to win $40.

Everyone hates losing more than they like winning, even the most risk-tolerant. And from that perspective, we are very motivated to do whatever we can in order to avoid locking in a loss, from which Sunk Cost Fallacy draws immense power.

This psychological urge is another powerful driver of Sunk Cost Fallacy. We don't want to deviate from past positions. In part because, "If I was wrong about that, what else might I be wrong about?" And in part due to a confused sense of virtue associated with staying consistent, or of flip-flopping deficiency associated with changing positions.

Never mind this perspective stands in direct opposition to agility. It nonetheless encourages us to dig in our heels and lean into Sunk Cost Fallacy to drive our decision-making.

A final emotional contributor to Sunk Cost Fallacy is that of hope. Our resilience is driven by hope, but it can also powerfully affect our judgment.

Common Examples and Effects

Sunk Cost Fallacy is both pervasive and profound. It affects us in small ways and large ways:

Despite its capacity to drive irrational decision-making, we cannot eliminate Sunk Cost Fallacy any more than we can eliminate "sadness." Our only rational choice is to understand it and factor it into our conscious evaluations. Especially at work.

Sunk Cost Fallacy and Organizational Decision-Making

As with any bias, Sunk Cost Fallacy adjusts to its context. Possibly its most abundant example is in regrettable talent retention. Virtually every organization has employees whose performances would warrant terminations, but whose tenures made those exits feel beyond reach.

Sunk Cost Fallacy is also heavily enabled by Status Quo Bias, the tendency for people to leave things unchanged. The desire to avoid change can easily encourage re-investments in failing strategies, another reason we often fail to address tenured but under-performing employees.

Beyond talent, however, the opportunities for Sunk Cost Fallacy to drive organizational behavior are very wide. Investments in new software, new technologies or new tools can drive organizations to double-down on enhancement and adoption long after sufficient data that doing so is a mistake. Ineffective sales and marketing campaigns are extended because the initial investment was too high for a short run. Failed acquisitions receive additional investment to protect the investment already made.

Perhaps the most complex sphere of organizational life relative to Sunk Cost Fallacy is innovation. Knowing when to continue investing in innovation, and when to pull the plug, is one of the most difficult tasks in business, and impossible to do perfectly. (It certainly helps to be conscious about it.)

But the most dangerous sphere of organizational life relative to Sunk Cost Fallacy is leadership. If leaders feel their status or position is tied to a particular decision, they may be more motivated to prove themselves right than protect the organization's interests, consciously or not.

The Existing "Solutions" for Sunk Cost Bias

The solutions most commonly offered to combat Sunk Cost Fallacy are very much aligned with most biases. Maintaining awareness during evaluation, using decision matrices and relying on data are among them.

And these solutions, when attempted, tend to produce great results. The problem is that these solutions are so infrequently attempted.

That is understandable for a number of reasons: it's far too much work given the sheer number of decisions we have to make, and we have far too little mental energy to do so.

For individuals, better decision-making requires intention and discipline, while groups require coordination and facilitation. But even those not enough to overcome Sunk Cost Fallacy, because they still fail to address the most powerful obstacle of all: emotional resistance.

The New Solution for Sunk Cost Fallacy

If following a structured decision-making process might make someone's past decisions seem foolish, it eliminates their motivation to do it. No one wants to appear stupid, to themselves or especially to a group. If forced into a group structured decision-making exercise, they will be concerned exclusively with impression management, muddying the waters for an honest and objective evaluation.

The point must be made forcefully and effectively upfront: errors in judgment from biases and heuristics are as universal as breathing. Every single human has and will make countless errors in judgment, both consciously and unconsciously. And hindsight is always 20/20. To feel foolish for making errors in judgment is, quite literally, foolish. And it is a huge blocker to growth and improvement.

This mindset is a requirement for an objective evaluation, and facilitators must be skilled in making the point. But even that is not enough.

People's status and positions are often tied to past decisions and/or supportive of the status quo. As such, they are strongly motivated to avoid or muddy any exercise that might threaten that order. This resistance must be eliminated as well. Fortunately, there's a framing to get us there.

Stories of agility success, like Play-Doh, Frisbee and Netflix, and of agility failure, like Kodak and Blockbuster, help to drive the point home.

What makes this the "new" solution to Sunk Cost Fallacy is that it addresses the emotional blockers before proceeding to the cognitive exercises. Solutions are meaningless for people not motivated to use them.