Episode 1: Sunk Costs & Escalation Traps

Intro

Hey, it’s Dallas and I have a question for you.

But first, let me give you some context.

Let’s say you’re an avid skier and each year, you and your best friend pick a new place to go skiing. Every year you rotate who picks where you’re going. This year it’s your turn. It’s up to you to choose where the two of you are going to go skiing, so you hop on the Google machine and start looking at some options.

Just then, you find a great deal on lift tickets for Granite Mountain in Wisconsin. Add to cart, and $500 later you’ve got a pair of tickets.

All of a sudden you get a phone call from your best friend and ski partner. They’re super excited to tell you about the amazing deal they just got at Mad River Mountain in Ohio. Two lift tickets for only $250!

Just then you realize it actually isn’t your year to pick where you’re going skiing.

But don’t feel too bad. With that whole COVID year in there, these things tend to happen.

But nevertheless, now you’ve got two sets of ski tickets for the exact same weekend.

Adding to the dilemma, both sets of tickets are non-transferable and non-refundable. You’re stuck.

Lastly, once you confess to your skiing buddy, you find out that the $250 tickets in Ohio are going to make for an undeniably better skiing trip. Better snow, more runs, a freestyle park and more.

So now you’re faced with a decision. Do you choose to use the more expensive, $500 tickets, or the cheaper, $250 tickets that you’re certain will actually make for the better trip?

Again, do you use the $500 tickets, or the cheaper, $250 tickets that will actually be the better trip?

Take a second to consider it….

Okay, got it?

Given that we’ve already decided that the $250 tickets will be a better trip in terms of pure enjoyment, and there are no other distinctions between the two locations, it’s obvious that you should choose to use the $250 tickets and just throw the $500 tickets in the trash.

However, 54% of people will knowingly choose the more expensive, less enjoyable trip, skipping the better experience because they’d rather waste the $250 tickets, even though it’s a better overall experience.

So, what’s happening here?

Let’s take a quick break and we’ll dive in…

The Research

The question I asked you is referred to – kind of obviously – as the “Ski Trip Problem.” It comes from a 1985 research paper titled “Organizational Behavior and Human Decision Processes,” by Hal Arkes and Catherine Blumer.

The Ski Trip Problem is one of many experiments Arkes and Blumer conducted to understand how deeply human decision making is impacted by what Richard Thaler coined a few years earlier as the Sunk Cost fallacy.

In another experiment, Arkes and Blumer separated people into two groups.

In one group – Group A – respondents were told that they were the lead of a $10 million research project to develop a new military aircraft. After $9 million dollars has been invested, they receive news that a competitor has just entered the market with an aircraft that is way faster, cheaper to make, and far more likely to succeed. It’s a better aircraft than they could ever make. Group A’s aircraft is dead in the water. Then, as the project lead, they were asked if they should continue the project, spending the remaining $1 million dollars, even though they know it will be in a losing effort, or if they should cut their losses, end the project early and put the remaining $1 million into a new project.

The second group – Group B – is posed with a similar problem. Except, before their project begins, before any money is spent, they receive news that a competitor has also just kicked off a similar research project. And that competitor is far more likely to build a faster, cheaper plane. Again, no chance of success. Group B’s aircraft is also dead in the water.

Both projects have the exact same future outlook – $10 million dollars spent and a failed project.

But, despite no indication of financial or business success in their future, 85% of people in group A – the group that already invested $9 million dollars – decided to continue the project, essentially lighting the last million dollars on fire.

In Group B – where no money had yet been spent – 83% of people decided to shut the project down before it began.

Again, in absence of any compelling reason to complete the project, only one reason stands out as to why Group A pressed on: Sunk Costs.

While the airplane experiment is an extreme one, sunk cost problems occur all around us – everyday. These problems cause us to stick with a certain course of action simply because we’re invested in it, even though a new course of action is clearly more beneficial.

For example, employees work underpaid jobs for bosses they hate because they’ve found ways to deal with it and they don’t want to start over as the new person at a new job.

People stay in toxic relationships because it wasn’t always that way and if they leave now, they aren’t sure they’ll ever find a person they love again in the future.

People let their debt pile up because what’s another $5,000 loan when they’re already $50,000 in debt?

Employers stick with underperforming employees because it will take time, energy and it’s costly to hire and train a new employee.

Sunk cost is losing six hands of poker in a row and then going all in on the seventh hand, because there’s no way you can lose seven in a row. When, in fact, every hand of poker is a brand new hand and not associated with the prior six, and you certainly can lose seven in a row.

This is also known as throwing good money after bad money.

These are all examples of the sunk cost fallacy. And it’s happening to all of us on a daily basis. Think about a project you’re actively spending way too much time on, or a relationship you’re over invested in. Then ask yourself why?

It’s happening to you too.

Why It Works

So why is sunk cost so difficult to overcome?

Why do we – that is all of us – continue to foolishly pursue jobs, projects, relationships, investments, and more, even long after it becomes clear that selectively quitting and doing something else instead will be more beneficial in the long term?

Maybe one way of helping to frame the problem is to use another name for sunk cost fallacy – that is, escalation of commitments. Or the escalation trap.

Where sunk costs tend to be associated more closely with financial or labor costs, escalation of commitments helps us frame the problem in another light. That is, as we continue to build commitments to a person, group of people, our children, or a home project, it becomes harder to overcome our personal egos and walk away from these commitments even when it’s apparent that they no longer serve us or the people impacted by the initial decision.

So why does this happen?

At the simplest level, we as humans, on a psychological level don’t like to “waste” things.

In our ski trip problem, using the more expensive ski tickets means we’re limiting our perceived waste. We’re only “wasting” the cheaper, $250 tickets. If we were to actually use the cheaper tickets, then we’re doubling our waste by not using the more expensive tickets. Our perceived waste increases from $250 to $500.

Also, we feel worse about ourselves. We feel guilty. Even when we tell ourselves the $250 ticket is the better trip. We willingly sacrifice our future enjoyment to not feel so bad about ourselves today.

The loss of $500 feels greater than the loss of $250, even though no matter what you decide, you’ve still spent the exact same amount of money. Whether you choose the cheaper or more expensive option, you’ve still spent the same amount of money, the cumulative $750.

Another potential reason that sunk cost is hard for us to overcome, is that we as leaders and decision-makers don’t like to see ourselves as people who make losing decisions. This causes us to stick with our decisions in the hope that eventually it will pay off and we will feel justified in our decision-making.

This outlook – this commitment trap – is exacerbated when others are involved and are also potentially impacted by the sunk costs we’ve committed to. Not only do we not want to view ourselves as poor decision-makers, we tend to double down on our decisions and commitments to avoid appearing to others as poor decision-makers. We don’t want the external perception of who we are as leaders to become that of a person who has flakey commitments. Especially when that’s the opinion being formed by our bosses, our children or our spouses. This causes us to hang in there longer for a potential future payoff which would validate our decision to ourselves and those around us.

Another cause is pretty basic – we’re wired to please. Please ourselves and those around us. And we don’t like saying “no.” This is often the root cause of an escalation of commitments.

The escalation of commitments can come in many forms – promising to take your children on a vacation, which then escalates to include a nicer resort, a theme park, skyrocketing gas prices, an extra night. We keep escalating our commitments in this situation because it feels good to your family and you don’t want to disappoint them. But at a certain point, each additional commitment isn’t returning the same value of increased joy, in fact at a certain point, each additional commitment can cause the total enjoyment to decrease due to the rushing around, not having enough time to truly enjoy the vacation, not having enough money left in the budget to maximize each stop and so on.

Escalation of commitments can lead to too many social events, just one more happy hour, one more networking event, one more wedding. You fall into this escalation trap because you went to Betty’s baby shower, so you better be at Linda’s wedding shower, and the week after that is Joni’s birthday party which you definitely can’t miss.

In a vacuum, each “yes” is minor. Each commitment is usually small. But as these ‘yes’s compound, and we look back at the entire commitment chain, we often find ourselves overwhelmed by the entirety of the commitment – we’re trapped. Removing one commitment from the chain – unless we plan to remove all of the commitments – is often seen as pointless, and removing all of them is painful and a major let down to those that it impacts.

When we’re trapped and there is no obvious path back out, the path of least resistance is to stick with the original decision, to maintain your commitment. Even when we know it’s more beneficial to make a new decision.

What To Do About It

So, how do we deal with this? If this is such a persistent problem in all of our lives, what can we do about it? How do we know when it’s time to cut our losses and quit on bad decisions to avoid sunk costs and get out of escalation traps?

The first step to overcoming sunk cost decision making problems is to have a basic understanding of the problem itself. Hopefully, we’ve checked this box by now…

But if not, here is an example that proves education and awareness is key. When the ski trip problem was tested across two groups – psychology students explicitly educated in sunk costs, and another group of students with no explicit education on the topic – the students with an understanding of sunk costs and it’s negative results were far more likely to recognize the situation, cut their losses and make a new decision, that was more beneficial to themselves or their teams. The group with no prior knowledge of the sunk cost problem failed to recognize the problem, becoming much more likely to continue with their original decision, sinking additional costs and digging themselves in deeper.

Put simply, have awareness of when you’re dealing with sunk costs, or when you’re stuck in an escalation trap. Be on the lookout. Call it out immediately to yourself and those around you. At least prompt the discussion early and often. Ignoring it and getting in deeper is not the right solution.

The next step is accepting accountability for the decision. Even when we’re educated and aware of sunk cost frameworks, it’s proven that we still have a tendency to stand by and let sunk costs pile up if at the end of the day we are not the ones accountable for justifying the decision making, or the outcome of the project.

But guess what? That’s pretty shitty. You, as a leader – of your colleagues, family or friends – are accountable for any decision you’re playing a role in, regardless of if you’re the one who has to justify it if it fails. Maintaining a consistent track record of accountability and successful decision making is what separates good leaders from the bad ones. It’s what makes people want you on their team or to be on your team, it’s what makes people want to have your back in the future, when it is you that’s accountable, when it’s your reputation on the line. If you want people to have your back, that starts with having their back.

And, who is to assume the accountable person is equipped with the situational awareness to recognize that they are in an escalation trap? Maybe you’re the person who can pull them – and you – out of the hole that is being dug.

That’s what being a leader is about.

We talked about awareness of the problem, let’s call this acceptance of the problem. Accept that the sunk costs and bad decision making are going to negatively impact you whether you’re accountable to it or not, and accept that you’re also accountable to setting a new course of action before it’s too late.

Another major problem that results in our undisciplined pursuit of bad decisions is our own stupid egos.

What we talked about earlier in this episode is that we as individuals, don’t want to hold a belief about ourselves that we’re poor decision makers, or that we create waste through our decisions, either financial waste, labor waste, time waste – whatever, we don’t want to envision ourselves as wasteful people. This effect is doubled when other people are involved. Not only do we not want to see ourselves in this light, we really don’t want others to view us as wasteful people. Especially our bosses.

We don’t want to be viewed as the leader who makes a decision, or a commitment, points the team in a certain direction and then comes back with a new commit, a new direction, a new set of goals and a whole new roadmap to get there. We don’t want to be the leader that is hard to follow because we don’t appear to have a clear outlook on where we’re going.

The fear of clouding your reputation, or your trustworthiness, in the eyes of the people you’re leading can cause you to dig your heels in and stick to your initial plan of attack even when it’s become apparent that it’s no longer the best plan.

What you’re doing when this thinking occurs, is you’re too closely associating your choices and your decision making with your identity.

You’re asking:

“If I make this decision, what does that say about me?”

In reality, it’s essential for leaders to know when the map no longer matches the terrain. When the decision or the plan no longer matches the desired future outcome.

As a leader you have to be able to read and adapt to situations, cut your losses and make difficult decisions that other people aren’t willing to make. If your team is going to make all of the right decisions without you, then there’s no reason to have you around at all anyways. So make the tough calls, change course as needed. Quit when you have to. That’s why you’re there. Competitors, markets and organizations are always changing, they’re fluid, and if you’re too rigid in your decision making – too dug in because of your ego, your competitors and your business’s opportunities in the marketplace will run you over and leave you for dead.

Lastly, maybe most importantly, know when to quit.

Quitting on time is one the most important skills you can acquire as a business owner or the leader of an organization. Contrary to popular belief, winners quit a lot.

For example, in Texas Hold’em, World Series winning poker champions fold their initial hand 75% of the time. 75% of the time, before the game even starts, the champion level player has quit. Even the non-champion, but still pro-level players fold their initial hand 70% of the time. Compare these two numbers to amateur poker players who fold their initial hand at an average rate of only 25%.

The professionals quit far more often than the amateurs.

Champion level poker players are making a decision in real-time to quit, based on future potential outcomes, based on their current chip count, based on their competitor chip counts, and not on what happened in the previous hand and not on how many chips they used to have, how much they dislike their competitors, or no matter how many people are watching. They are basing their right now decision, on right now information and the future consequences of that decision.

Each decision is a new decision. Unencumbered by the past.

When you find yourself struggling with sunk cost decisions – unlike a world champion poker player – you’re likely pulling too much of the past into the present to inform the decision. You’re using yesterday’s information to inform today’s decision. You’re thinking of the resources that have been invested, the promises that were made, you’re thinking about what it will mean for your reputation.

You’re also worried that quitting now, or changing direction now is too early. Despite clues in the present that it’s time to make a new decision, you will often find yourself negotiating with and against yourself.

But, guess what? When you quit on time, it always feels too early. That’s the point.

When quitting becomes the obvious choice, it only becomes obvious because things have gotten so grim that you have no other choice. That’s quitting too late. That’s far more risky than quitting early.

When you find yourself in a place where you’re not sure, when it’s too close to call between sticking to your original decision or making a new one, it’s likely that the new decision is the better choice.

By not quitting, by not making a new decision, you are missing out on the opportunity to change directions into something that will create more progress toward your goals.

Anytime you keep pursuing a losing decision, that is when you are slowing your progress.

Anytime you stick to something when there are better opportunities out there, that is when you are losing ground.

And as far as your team is considered, try saying this:

“I made a decision based on a certain set of information that I had available to me at that time. I now have new information available to me and based on that information, the smart thing for me to do is to make a new decision. And that decision is…”

Simple as that.

Dallas McLaughlin