Many of us grew up with this saying. And: (too) often we act accordingly. Loss-making stocks are kept in the portfolio, projects with no prospect of success are completed. No matter what additional costs this entails.
But why is it so difficult for us to revise decisions we have made? Here are some background details and how you can manage to limit losses from bad investments.
Let's start with a little thought experiment.
Imagine you are the president of an aircraft manufacturer. You have invested ten million euros in the development of an aircraft that cannot be detected by radar. When the project is 90% complete, a competitor begins to market such an aircraft that is more powerful and cheaper than the model your company produces. Should you invest the last 10% of the research costs in the project to complete the aircraft, or should you end the project early? (Situation A)
Most people think: "Well, the 10% doesn't matter now. And who knows, maybe the competition will fail or our marketing will be much better." We quickly find some more or less good reasons why the project should be completed.
But what if the framework of our example changes a little? How would you decide in this case?
You are the president of an aircraft manufacturer. An employee suggests investing one million euros in the development of an aircraft that cannot be detected by radar. However, a competitor has just started to market such an aircraft. It is foreseeable that this competitor model will be more powerful and cheaper than the model that your company can produce. Should you invest the money in developing the aircraft? (Situation B)
Most "imaginary" presidents reject this development proposal. But the two situations have amazing similarities. In both cases, it is necessary to decide whether or not to invest one million euros in a project with little to no chance of success. And yet we come to different decisions. If we were as rational as economic theories suggest, we would have to react the same in both situations. But we don't. Because for us humans it makes a difference whether we have already invested time and money in a project or not. In research, this behavior also has a name: the sunk cost effect. The Prospect Theory by Kahneman & Tversky (1979) explains clearly why we decide differently in situation A than in situation B.
The Prospect Theory was developed on the basis of empirical findings as an alternative to the expected utility theory of classical economics. It describes decision-making in situations of uncertainty and insecurity and takes cognitive distortion phenomena into account.
The expected utility theory assumes that decisions are geared towards the end state and made with a view to total assets. Thus, in both situations A and B, we should compare the investment of 1 million euros with the expected result. Accordingly, in both situations, we would have to reject the investment. In both situations, a negative result seems likely.
This theory contradicts observations in practice. This is because we take into account not only the future (end result) but also the past (previous investments) in our decisions. We therefore react more to the relative change to a reference point (previous investment amount, purchase price, time investment). We pay attention to what change a decision causes compared to our reference point.
Figure 01 shows the basic assumptions of the Prospect Theory. Based on our reference point, we judge whether a situation represents a gain or a loss for us. As the curves show, we have a decreasing sensitivity to gains and losses. This decreasing sensitivity explains why we decide differently in situation A than in situation B.
Let us first consider situation B. We have not yet made any investments and, based on the information available, the start of aircraft development would probably result in a loss of 1 million euros. The associated perception of loss or the perceived pain of loss is high (Figure 2, right-hand edge). We are therefore inclined to reject the project.
In situation A, we have already invested 9 million euros. The currently perceived pain of loss is high. Investing another million would only change our subjective perception of loss slightly. The pain of loss of one million on the final investment is significantly lower than that of a new investment of one million (see Figure 2, left-hand edge). Thus: It is not the absolute value but the relative change that influences our decision-making behavior.
In our example, in addition to the factor "relative change to the reference value", the factor "hope" also plays a decisive role. Losses are only perceived as such when they are realized and thus subjectively reality. This tempts us to throw good money after bad. Because: As long as a project is not completed and you remain invested in a share, you can hope that things will turn out for the better. The price for this hope is usually very high. A price that we would not be willing to pay under other circumstances. Just think of situation B.
How can each of us avoid the sunk cost effect? Very simple. If you need to reconsider an investment decision you have already made, ask yourself the following questions:
If I were my successor, how would I continue with this project? What would be my reasons for abandoning it?
If I saw the project for the first time today, how would I decide? What would be my main reasons?
If I withdraw the capital from this project, from this investment, where can I invest instead?
Questions 1 and 2 allow you to reduce the influence of the past. Your decisions are influenced less by the past and more by the expected future. Question 3 allows you to see which alternatives you would miss if you continued the project or kept the investment.
This can also be painful. Behavioral economics and decision theory include numerous other exciting and important results and models. We would be happy to advise and support you in integrating and applying behavioral economics findings into your management and organization.
References:
Ariely, Dan (2008): Denken hilft zwar, nützt aber nichts. Warum wir immer unvernünftige Entscheidungen treffen. München, Droemer.
Braun, Walter (2010): Die (Psycho-)Logik des Entscheidens. Fallstricke, Strategien und Techniken im Umgang mit schwierigen Situationen. Bern, Verlag Hans Huber.
Gigerenzer, Gerd (2008): Bauchentscheidungen. Die Intelligenz des Unbewussten und die Macht der Intuition. Goldmann Verlag.
Jungermann, Helmut (2010): Die Psychologie der Entscheidung. Heidelberg, Spektrum akademischer Verlag.
Kahneman, Daniel; Tversky, Amon (1979): Prospect theory: An analysis of decision under risk. Econometrica, Vol. 47, No. 2, S. 263-291.
Kahneman, Daniel (2011): Schnelles Denken, langsames Denken. München, Verlagsgruppe Random House GmbH
Lindstädt, Hagen (2007). Problemlösen und Verstehen bei ökonomischen Agenten – Eine Gegenüberstellung ökonomischer und kognitionspsychologischer Modelle regelbasierten Entscheidens. Neuro Psycho Economics, 2 (1), 30–43.
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