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Behavioural Finance Free

Sunk Cost Fallacy

The sunk cost fallacy is the tendency to continue with an investment or decision because money, time, or effort has already been spent, even when future prospects no longer justify continuing.

Definition

A sunk cost is a cost that has already been incurred and cannot be recovered.

In behavioral finance, the sunk cost fallacy occurs when investors let past losses influence future decisions, even though those past costs should no longer affect what happens next.

For example, an investor may continue holding a weak stock because they have already lost ₹1 lakh on it.

They may think:

“I have already lost so much, so I should wait until the stock comes back.”

However, the correct question is whether the investment still offers attractive future prospects compared with available alternatives.

The sunk cost fallacy can lead to:

  • Holding losing investments for too long
  • Continuing failed business projects
  • Adding more money to poor investments
  • Avoiding necessary portfolio changes
  • Ignoring better alternatives

The key principle is that past unrecoverable costs should not determine future decisions.

Practical Example

Holding a Losing Stock Because of Past Losses

Suppose Rakesh invests ₹3 lakh in a company.

The value of the investment later falls to ₹1.8 lakh because the company's business outlook has weakened.

Rakesh believes the stock is no longer attractive, but he refuses to sell because he has already lost ₹1.2 lakh.

He keeps holding only because he wants to recover the original investment.

If better opportunities are available elsewhere, this decision may cause further losses.

This shows how the sunk cost fallacy can cause investors to focus on money already lost instead of evaluating future returns objectively.

History & Context

1970s

Research on Escalation of Commitment

Psychologists and economists increasingly studied why people continue investing resources in failing decisions.
1980s

Sunk Cost Effect Studied Formally

Researchers such as Hal Arkes and Catherine Blumer examined how prior investment of money, time, or effort influences future choices even when those costs cannot be recovered.
Today

Important Behavioral Finance Bias

The sunk cost fallacy remains important in understanding loss persistence, poor capital allocation, project continuation, and reluctance to exit failing investments.