In this video I introduce the sunk-cost fallacy, which is when we make present decisions based on previous investments which aren’t relevant. This fallacy can occur in the form of gamblers or investors who make increasingly risky decisions in order to make up for past losses. Tversky and Kahneman have suggested that part of the reason for this fallacy is that people tend to keep separate mental accounts of the costs of things, which then causes them to do things to even-out those accounts rather than thinking rationally of a single mental account.
Daniel Kahneman – Thinking, Fast and Slow (Amazon) http://amzn.to/2nAWnop
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Hi, I’m Michael Corayer and this is Psych Exam Review. In this video we’re going to look at another potential error in our decision making and this is the sunk cost fallacy. The sunk cost fallacy refers to when we make present decisions based on previous investments. So for instance, a gambler who’s been losing money starts making increasingly risky bets, bets more and more in hopes that they can make up for those past losses.
Now the reason that this is a fallacy is that these present odds of winning are not influenced by the previous losses. They don’t know that you’ve already lost a bunch of money on this game, so it’s a fallacy to let those influence your decision making. We also see this with speculative investors who’ve lost money for themselves or for clients and so they start making riskier and riskier investments and they actually start making investments that they would otherwise never make, right? Things that just are not good investments, they start making them in hopes that one of them will pay off and it will make up for all those previous losses and again this is a fallacy because those previous losses don’t have any influence on the present investments.
So the important point here is that this becomes a fallacy when those past investments are not relevant and that’s most obviously the case when we look at things like gambling or making a new investment, right? Because, you know, the blackjack table doesn’t know whether you’ve won or lost in the past. The same way investing in a new company isn’t going to be influenced by your previous successes or losses.
Ok, so there are some situations where we allow previous investments to influence our present decision making but it’s probably not considered a fallacy and the reason for that is those previous investments are actually relevant to the present decision made. For instance if you’re thinking about abandoning a relationship or quitting your job these are situations where you’ve made from some pretty substantial previous investments.
Let’s say you’ve been in a relationship for the past five years and so you probably want that to influence your present decision-making, right? You shouldn’t just throw that relationship away for no good reason because you know that you don’t get to start five years in in the next relationship. You have to start all over again and so you’re going to have to reinvest a lot of time and effort into a new relationship and you’ve already invested that in this current relationship. So maybe you should be careful in how readily you abandon it.
Similarly if you’re thinking about quitting your job because of you know some minor annoyance, right? You should, maybe you think about just quitting your job on a whim, saying “That’s it, I’m out of here”. Well if you think about the previous investments that you’ve made in this job maybe it doesn’t make sense to do that because if you quit your job now you have to start over somewhere else. You have to meet new people, learn how to work with them, sort of get a feel for the new culture in this new work environment, and that’s going to take a lot of time and effort and maybe you’ve already invested that time and effort into your present job. Maybe you should just view this as a minor annoyance, rather than a reason to quit the job.
Ok, so why do we make this sunk cost fallacy? Well some research by Amos Tversky and Daniel Kahneman suggests one possible explanation for why this happens. What Tversky and Kahneman did was they asked participants a question. I’ll read it to you here:
Imagine that you have decided to see a play where admission is ten dollars per ticket. As you enter the theater, you discover that you’ve lost a ten-dollar bill. Would you still pay ten dollars for a ticket to the play?
You can think about what you would do and I’ll tell you that eighty-eight percent of participants in this study said they would still buy a ticket. It’s a shame I lost ten dollars but I’m at the theater, I want to see the show, I haven’t bought a ticket yet so I need to buy a ticket now.
What Tversky and Kahneman also did was they did another variation of this question and they asked some other participants:
Imagine that you’ve decided to see a play and paid the admission price of ten dollars per ticket. As you entered the theater you discover that you’ve lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay ten dollars for another ticket?
Now in this case only forty-six percent of the participants said that they would buy another ticket but it’s really the same thing as the first situation, right? I mean you had something worth ten dollars and then you lost it and then you wanted to see a show, right? It shouldn’t matter that the ten-dollar thing that you lost was in the form of a bill or a ticket, it’s ten dollars either way. So why are people’s answers so different?
Well what Tversky and Kahneman suggested is it’s because people don’t think rationally. They don’t keep a single mental account of all of their costs. Instead they keep separate little accounts for the costs of different things. So in the first situation, people lose ten dollars but when they think about their theater cost, it’s not relevant. Ten dollars, but it wasn’t part of the cost of seeing the show, so it doesn’t count. I haven’t paid anything to see the show yet, so of course I’ll pay ten dollars to see the show. That’s what it costs.
But in the second situation what happens is when they lose a ticket now they start counting it in this mental account for how much does it cost to go to the theater. And so now they look at this theater account and it’s already at minus ten like “It’s already cost me ten dollars to see this show, I’m not going to pay another ten dollars. I mean I’m not going to pay twenty dollars to see a ten dollar show.” And so in this case, because of this separate mental accounting, they decide that it’s too expensive to buy two tickets for the same show and they don’t want to buy another ticket.
Now we can think about how this relates back to our sunk cost fallacy and that if people kept a purely rational single account they might not be as prone to making this error. But what happens is they start separating the costs of things into separate accounts and they start thinking about how much has it cost me at this blackjack table.
“How much am I down here?” You know, “Geez, I’m down two thousand dollars, that’s really bad. I can’t let my blackjack account sit at minus two thousand”, you know, “I need to win at blackjack. I need to make up for that” rather than thinking of a single sort of rational approach, would be you know “down two thousand dollars, I probably shouldn’t start making larger and larger bets at the blackjack table. That’s not very wise” but instead they’re looking just at that single account and saying “I can’t leave with my blackjack account at minus two thousand. I need to do something to get that back up” and the only thing to do to get that back up is to keep playing blackjack and hope that you win.
Alright, so this gives us a little bit of insight into why the sunk cost fallacy occurs. I hope you found this helpful, if so, please like the video and subscribe to the channel for more. Thanks for watching!