What is Sunk Cost? Meaning, Types and How to Avoid it

Sunk costs are money or resources you have already spent and cannot be recovered. Once this money is spent, it should not affect your future decisions. However, many still consider it while making choices. This leads to poor financial decisions because they focus on past losses instead of future gains.

For example, you might buy an expensive (non-refundable) gym membership but later realise that you don’t enjoy going to the gym. This money is a sunk cost, as you cannot get it back.

So, do you want to avoid sunk cost mistakes and make smarter investments? In this article, let’s understand the concept of sunk cost in detail and see how you can use it to make your investments better.

What is Sunk Cost?

Sunk cost represents money or resources that have been spent. You cannot recover them, no matter what decision is made in the future.

For example,

• Let’s say a company spends money on advertising or research. Even if the business changes its plan, the money cannot be recovered.
• Similarly, consider a shop owner who pays rent for the store. The money spent on rent is gone, regardless of whether the shop makes a profit or not.

Businesses and individuals should ignore sunk costs when making financial decisions, as these costs cannot be changed or refunded.

However, people often struggle to ignore sunk costs because they feel compelled to recover their past investments, even if it results in further losses.

Types of Sunk Costs

Sunk costs come in various forms. By understanding their types, you can make better investment decisions. Let’s check them out

1. Money Spent

This type covers payments like

• Non-refundable deposits
• Prepaid expenses
• Investments in projects and equipment that cannot be recovered.

For example, let’s say a business buys a machine for a special project. Upon the project’s completion, money spent on buying the machine is a sunk cost.

2. Time and Effort

If you spend a lot of time on a failed project, you cannot get that time back. Consider a company that invests 10 years in researching a product, only to have the government later ban its production due to environmental concerns. Here, the time and effort spent on research is a sunk cost.

3. Emotional Investment

Sometimes, people stay in jobs or business ventures because they have invested a lot of emotional effort, even though it may no longer benefit them. This emotional investment is also a sunk cost.

4. Depreciation and Amortisation

When a business purchases an asset like a machine, patent, or building, it does not deduct the full cost immediately from its profits. Instead, the cost of trading is spread over several years to portray a more accurate financial picture.

For example,

• Let’s say a company buys a machine for Rs. 10 lakhs. It does not deduct Rs. 10 lakhs from its profits in one year. Instead, it might deduct Rs. 2 lakhs each year for five years.

Since the money (Rs. 10 lakhs) has already been spent, the depreciation amount (Rs. 2 lakhs) is considered a sunk cost because it is only an accounting entry and does not represent an actual cash outflow.

Sunk Cost Formula 

You can find the total irrecoverable amount by identifying all expenses that cannot be recovered or reused. Follow these steps to estimate sunk costs:

1. List all the investments or purchases already made
2. Find the difference between the original price and the current resale value (if any).
3. If the item has no resale value, the entire cost becomes a sunk cost.

Examples of Sunk Costs 

For more clarity, let’s study two examples of sunk cost related to businesses and personal life:

What is Sunk Cost Fallacy?

The sunk cost fallacy happens when people or businesses continue with a bad decision just because they have already spent money, time, or effort on it. Instead of looking at the present situation logically, they stick to the original plan.

Why Does Sunk Cost Fallacy Happen?

This mistake happens because people trust emotions over facts. Instead of making data-driven decisions, they trust their instincts and stick with the original plan.

Example of Sunk Cost Fallacy 

For a better understanding of the concept, let’s study an example of a sunk cost related to investing

• Let’s say you buy shares of a company. Later, the company’s performance declines, and the share price starts to fall. A logical investor would sell the shares to prevent further losses. However, someone falling into the sunk cost fallacy might hold on to them instead.

Factors that Lead to the Sunk Cost Fallacy 

As discussed above, the sunk cost fallacy happens when people continue investing in a bad decision just because they have already spent money, time, or effort. Here are the main reasons why this happens

• Fear of Loss: People dislike losses more than they enjoy gains. They remain invested in failing projects because they don’t want to accept a loss.
• Emotional Attachment: When people invest time and effort into something, they develop a personal connection. This emotional bias makes it hard to let go.
• Desire to Avoid Waste: People don’t like wasting resources. Even if a project is failing, they continue investing because they feel stopping would mean their earlier efforts were wasted.
• Blame Game: If a person or a team is responsible for a decision, they might hesitate to admit failure. They fear being blamed for losses and may continue the project to avoid criticism.
• Overconfidence in Future Success: Some people believe that if they keep investing, they will eventually recover their losses. This overly optimistic thinking can lead to bigger losses in the long run.

How to Avoid Sunk Cost Fallacy?

The sunk cost fallacy usually traps businesses and investors. It forces them to sustain even more losses. Let’s see how you can avoid this mistake

• Understand the Sunk Cost 

Accept that spent money or effort is gone forever and cannot be recovered. Instead, focus on what’s best for the future.

• Think About Future Benefits

Always ask yourself, “If I had not spent money on this before, would I still invest in it today?” If the answer is no, then do not let past spending affect your decision.

• Set Clear Goals

When you have clear goals, you usually focus on future success and do not let past losses influence your decisions. This protects you from negative sunk cost effects.

How Does Sunk Cost Fallacy Affect Investors and Traders? 

Investors and traders are also humans, and in fact, trading and investing can test your psyche deeply. The sunk cost fallacy affects them in the following ways

• Holding onto Losing Stocks: Investors might hold onto a stock that’s consistently declining in value because they don’t want to realise the loss. They might tell themselves it will eventually recover, even if no evidence supports that.
• Averaging Down: This involves buying more of a stock as its price falls, hoping to lower the average purchase price. While this strategy can sometimes work, it can also lead to significant losses if the stock continues to decline. The sunk cost fallacy can make investors overly committed to this strategy, even when it’s not working.
• Ignoring Warning Signs: When the sunk cost fallacy influences investors, they may ignore or downplay negative news or indicators about a company or investment. They are reluctant to admit they made a bad decision and may seek information confirming their initial belief, even if it’s biased or unreliable.
• Missed Opportunities: Investors may miss out on other, more promising opportunities by clinging to losing investments. Their capital is tied up in a failing venture, preventing them from allocating it to use better.
• Emotional Distress: The sunk cost fallacy can lead to emotional distress, as investors experience regret, anxiety, and frustration. This can further cloud their judgment and make it even harder to make rational decisions.

Conclusion

Sunk costs are money, time, or resources already spent and cannot be recovered. This concept leads to the sunk cost fallacy, which occurs when people continue with their losing investments even when it’s no longer the best choice. They do so under the influence of emotions like fear of loss or emotional attachment rather than logic.

The sunk cost fallacy prompts traders and investors to remain invested in falling stocks. They focus on past investments instead of future outcomes.

By recognising sunk costs and focusing on future benefits, businesses and individuals can make more rational choices. This can lead to improved outcomes and reduced losses.