Sometimes your brain can be your worst enemy. “The brain drives much of our decision-making behaviour in the wrong direction because it needs to create simplicity, remove complexity, look for certainty and build the future on the past,” says Dr Amanda Potter, Founder and CEO of Zircon Management Consulting and host of The Chief Psychology Officer podcast.
One issue that often drives business owners in the wrong direction is that of sunk costs. These are those expenses already paid that cannot be recovered. The fear of being unable to recover that previous investment can lead business owners to continue to invest in unprofitable projects, despite all evidence to the contrary. If you continue to throw good money after bad, you are in the grips of the sunk cost fallacy.
But by recognising the warning signs and using the right tools, you can start protecting your business today.
Where does the sunk cost fallacy come from?
In 2002, psychologist Daniel Kahneman won the Nobel Prize for his work on cognitive biases in business decision-making. This work included the sunk cost fallacy, and economist Richard Thaler built on this theory to understand why people keep investing in services that don’t provide rewards.
Scientists Hal Arkes and Catherine Blumer expanded on Thaler’s hypothesis, conducting a series of experiments that illustrated how the idea of sunk costs influences our decisions. They found that ego is linked to high-investment projects.
Investing in a new project, service or idea can be an ego-driven decision, especially when presented to people you want to influence. "The ego is associated with self-esteem and one's self-image," says Dr Potter. "That can influence our ability to be rational."
The sunk cost fallacy is a classic example of where rational thought is overcome by emotion, and our actions are out of step with the reality we are facing.
Why are some business owners more vulnerable to the sunk cost fallacy?
Susceptibility to the sunk cost fallacy in business comes from both psychological and environmental factors. Factors such as overconfidence, making decisions based purely on emotion, and a lack of peer support can potentially lead business owners to make decisions that may not yield the desired outcomes.
Ego-driven decisions
“Ego-driven decision-making drives us away from being logical and rational,” says Dr Potter. It can lead us to reject new data showing we made a bad decision, because it threatens our ego and sense of self-worth. For example, say you invest £75,000 in new product development. After three months on the market, the product is only capturing 30% of the revenue that was forecast. Continuing to invest in this product will only increase the sunk costs. You’ve already spent £75,000 which cannot be recouped. Adding more spend on marketing and product development will only compound your error. Based on the figures you should clearly drop the product, but your ego may cause you to press on with this loss-making venture.
Ignoring dissonance
Ego-driven decisions are emotional decisions. When subjective emotions and objective facts clash, you experience a phenomenon that psychologists call cognitive dissonance. “This conflict causes a feeling of distress," says Dr Potter, "because the systems in your brains are trying to drive you towards a singular path of success."
In creating protection from distress, your brain nudges towards simplistic sources of dopamine, one of our ‘happiness hormones’. This can mean tending towards what you have always done in the past and avoiding the "risk" of changing course.
Tackling the sunk cost fallacy is therefore vital not only to avoid wasting further investment, but also to strengthen the character traits that so often make entrepreneurs successful.
“Avoiding risk doesn't teach you to be curious," says Dr Potter. "It doesn't teach you to change.”
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Resisting the sunk cost fallacy
Overcoming our brain’s safety-seeking behaviours isn’t hard, says Dr Potter. It’s about shortening the time between a sunk cost appearing, recognising the situation and course-correcting.
Dan Morris is Founder of Arrive Design Agency and also Found, a CRM system for care homes. In 2018 he launched an online recruitment platform for the care sector, called Canu, which ultimately failed.
"We launched the concept to market and quickly built up a database of over 10,000 candidates and also over 100 social care operators trialling the platform," says Morris.
"However, we were too broad with our targeting - going nationwide with a relatively small budget and trying to make an impact against incumbent recruitment platforms. This stretched resources and the impact was not great enough. Yet we persisted. We stuck with this strategy for too long before pivoting."
Morris said that his key lesson from the experience was to learn how to "fail fast" and adapt to situations quicker.
Mindfulness, technology and culture
“The practice of mindfulness helps us understand why there's dissonance between what we want to see, and what is really happening”, says Dr Potter. Understanding this dissonance allows us to move away from emotive, irrational responses and towards strategic, evidenced decisions.
In addition, make sure you’re using accurate technology and tools so you can trust the facts.
With the facts in hand, evolve a culture of collaborative decision-making. Understand the skills of your senior team, where they can add to your knowledge base and proactively seek their advice.
Seek objective advice
Leadership can be lonely, which can compound errors. Separating fact from feeling is essential to avoid major sunk costs.
Articulating your concerns around sunk costs to unbiased people can powerfully affect the brain. “When we are highly stressed because there’s high investment in an outcome, the prefrontal cortex diminishes, says Dr Potter.
"We're less able to recognise the need to detach emotionally from that investment even though it's no longer rational or logical."
Cultivate wider networks and engage your peers' counsel with complex challenges.
Take swift action
Learning to let go of the past and make swift decisions will help you avoid the sunk cost fallacy. Morris says: “Try not to become too emotionally invested in a sinking ship.” Look at your situation with curiosity and try to learn what’s happening.
Remove the shame and ego. And, says Dr. Potter, stop seeking the dopamine from looking at past successes, “because when we’re feeling good, we have the belief that it’ll work again in the future.”
The most effective tactic to avoid the sunk-cost fallacy is recognising it. Overcoming knee-jerk reactions isn’t easy, but it gets simpler.
Work through cognitive dissonance, understand your need for dopamine and take a breath. Review the facts, ask your trusted advisors and then take your next steps towards real, validated success.
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