Sunk Cost Fallacy: Throwing Good Money After Bad

Key Takeaways

• The sunk cost fallacy is continuing a course of action to justify resources already spent and unrecoverable.
• Arkes and Blumer documented it in 1985 across ten experiments in their paper The Psychology of Sunk Cost.
• A rational choice weighs only future costs and benefits, never money, time, or effort already gone.
• In markets it produces averaging down into losers and refusing to sell, deepening avoidable losses.

What It Is

A sunk cost is a cost already incurred that cannot be recovered, no matter what you decide next. The sunk cost fallacy is letting that unrecoverable cost drive your forward-looking decision. You stay in a project, a trade, or a position because you have already committed money, time, or effort to it.

Hal Arkes and Catherine Blumer named and tested the effect in their 1985 paper, "The Psychology of Sunk Cost," in Organizational Behavior and Human Decision Processes. Across ten experiments using scenarios from theater tickets to ski trips to aircraft programs, people kept funding the prior choice far more often than the forward-looking value justified.

The Intuition

Quitting feels like admitting waste, and waste feels shameful. Arkes and Blumer linked the bias to a deeply learned rule from childhood: do not be wasteful. Walking away from a half-finished commitment trips that rule, so people press on to make the prior spending feel worthwhile.

The catch is that the money is gone either way. Continuing does not recover it. Continuing only adds new costs to old ones if the forward outlook is poor. The rational test is simple: forget what you spent, and ask whether you would start this commitment today at its current price, knowing what you now know.

How It Works

The fallacy combines with loss aversion, the finding that losses hurt more than equal gains feel good. Selling a losing stock turns a paper loss into a realized one, which feels worse than holding and hoping. So investors hold, and often add more, to avoid that sting.

It pairs with the related idea of escalation of commitment, where each added investment makes withdrawal harder, because more is now at stake to justify. The counter is to separate two questions cleanly. The past question, how much have I spent, is irrelevant to action. The future question, what is the best use of my next dollar and my current capital, is the only one that should drive the trade.

Worked Example

You buy 100 shares at 50 dollars each, a 5,000 dollar position. The company posts weak earnings and the stock drops to 30, a 2,000 dollar paper loss. Your thesis is broken, and a fair forward estimate now puts the stock at 28.

The sunk cost reasoning says: I cannot sell at a 2,000 dollar loss after all this, I will buy 100 more at 30 to lower my average cost to 40. Now you hold 200 shares and 8,000 dollars at risk in a stock you would no longer choose to own.

The correct frame ignores the original 50 dollars entirely. The only live question is whether 28-dollar shares with a broken thesis are the best home for 6,000 dollars of capital today. If a healthier stock offers a better forward return, selling and redeploying beats averaging down. The original loss is sunk; protecting your ego from it just risks turning a 2,000 dollar loss into a far larger one.

Common Mistakes

1. Averaging down to lower cost basis. Adding to a loser to reduce your average price is sunk cost reasoning in disguise. Add only if the position is your best forward opportunity on its own merits.

2. Holding to break even. Refusing to sell until a stock returns to your purchase price ties the decision to a number the market does not care about. Break even is about your past, not the stock's future.

3. Counting time and research as reasons. Hours of analysis already spent are also sunk. They do not make a weak thesis stronger.

4. Funding failing projects. Companies and investors keep pouring capital into doomed ventures to honor prior spending. The aircraft scenario in the original research showed exactly this.

5. Confusing it with a real averaging strategy. Planned, rule-based dollar cost averaging into a sound long-term holding is different from emotionally rescuing a broken position. Know which one you are doing.

Frequently Asked Questions

What is the sunk cost fallacy in investing in simple terms? The sunk cost fallacy in investing is holding or adding to a losing position because of money you already spent. A good decision looks only at what happens next, not at costs you cannot recover.

How does the sunk cost fallacy affect investment decisions? It makes investors hold losers too long and average down to avoid realizing a loss. As the share example shows, this can turn a manageable loss into a far bigger one by tying up more capital in a broken thesis.

What is a real-world example of the sunk cost fallacy? Buying more of a stock that fell from 50 to 30 just to lower your average cost, even though the thesis is broken and the same money would do better elsewhere.

How can investors avoid the sunk cost fallacy? Ask whether you would buy the position today at the current price, knowing what you know now. If the answer is no, the prior spending is irrelevant and you should consider exiting.

How is the sunk cost fallacy different from the disposition effect? The sunk cost fallacy is holding losers because of past spending. The disposition effect is the broader pattern of selling winners too early while holding losers too long, of which sunk cost reasoning is one cause.

Sources

1. Arkes, H.R., & Blumer, C. (1985). "The Psychology of Sunk Cost." Organizational Behavior and Human Decision Processes. https://ideas.repec.org/a/eee/jobhdp/v35y1985i1p124-140.html
2. BehavioralEconomics.com. "Sunk cost fallacy." https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/sunk-cost-fallacy/
3. Semantic Scholar. "The Psychology of Sunk Cost" (Arkes & Blumer). https://www.semanticscholar.org/paper/The-Psychology-of-Sunk-Cost-Arkes-Blumer/e4564b88ca2349962a707b76be4c75076ad6bd43
4. IZA Institute of Labor Economics. "Evaluating the Sunk Cost Effect" (Discussion Paper). https://docs.iza.org/dp14257.pdf

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.