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Sunk Cost Fallacy, Loss Aversion and Endowment Effect Explained with Examples

4,721 views Wait, is this logic right? • Oct 22, 2023
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Slog Reference: Why me make stupid financial decisions

Description

Why do we make stupid financial decisions? The answer lies in the millions of years of conditioning, sunk cost fallacy, loss aversion bias and endowment effect. What do all these things mean, and how do these affect your financial decisions? Find it out in this episode of the FutureIQ podcast.

We've explained the sunk cost fallacy experiment with the help of some real-life examples that you may relate to in trading, economics, marketing, sales, gaming and many other places. Learn this now.

More videos for you:
Finishing Every Book Is a Waste of Time - 6 Hacks to Read More, Better, Faster: https://youtu.be/yViCi9qhzC4
Psychology Of Persuasion: https://youtu.be/lEvzk05XzOg
Slippery slope fallacy: https://youtu.be/AdCXjrkK3hw
Dollar value of time: https://youtu.be/C-8gffw9_h4

REI Article: https://www.psytoolkit.org/survey-library/thinking-style-rei.html

Hope you enjoyed FutureIQ by Navin Kabra and Shrikant Joshi. Do hit us up on Twitter:
@ngkabra http://twitter.com/ngkabra
@shrikant https://twitter.com/shrikant

Listen it on the podcast provider of your choice: https://tapthe.link/FutureIQRSS
Watch other episodes of The FutureIQ podcast: https://www.youtube.com/playlist?list=PLAppTB0r5_TaYueZ0adD42Wiw5X-wTE4v

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Transcript

imagine you have gone for a movie and it turns out to be a very boring movie okay do you get up and walk out or do you sit through it sit through it right suffer through it suffer through it because you paid for it and you want to oh yes that also also because I was responsible for reviewing movies at one point in time so I had to sit through and suffer through it but even though if I wasn't huh I would still sit through it yeah uh and so that's what uh I want to talk about today right this concept called sunk cost another example is that uh JW Marriott used to sell a yearly
membership right that uh for 10,000 uh rupees you get a bunch of things but also you get a 30% discount every time you eat there and now just to make sure I make full use of this I would want to go to Marriot again and again right so you can see the problem here right yeah right yeah why what what okay so basically the problem is that you have already spent some money or you have spent some effort and then you don't want that to be wasted true right so that's why you uh continue to do whatever it is that you started doing but take a different listen paaul has been a very old concept right but let's
understand this better okay let's take an example you have bought a stock okay for 200 rup okay and you think it is going to go to 300 right um now U month later there's some news that came out because of which people are a little unsure about what this company is doing you are a little unsure the stock goes down from 200 to 180 okay okay do you sell I you probably think you know what I've been with this I spent 200 I've been with this for a held on to it for a while let me if I sell now I'll be losing money on this stock right let me see what happens correct a different way
of thinking about it is that today if I told you do you want to buy this stock it is at 180 would you buy it probably not right so the thing is that if you didn't have the stock you wouldn't buy it at 180 but you already have the stock at 180 and you're just sitting with it because you know something is different that you spent some money on it earlier hold on I am not very well well vered with the stock market but not buying a stock is not the same as selling the stock why because selling the stock means I have to take a loss not buying means I'm not putting in money at all
there is no profit no loss yeah so see I mean if you even if you forget the transaction costs or the tax part of it right still people do make this mistake all the time right the main issue is that you get emotionally attached to something either the the process the amount you have spent on it and then the decision really is that just by sticking with it right now all that money that you already spent is not coming back that's correct so you have to take a decision based on what is the situation today and what is the best that is possible going forward right okay right so if there is a government which has
built half a bridge okay and uh then they realize that it is way over cost and the bridge is not going to be very useful in any case because traffic patterns have shifted and so on but they already spent so much money on the bridge should they continue building it or should they give up on it and do something else right wow that is a tough question no the point is that forget how much you spent so far huh from today onwards how much extra do you have to spend and is it worth it that's the only question worth asking right because no if the fact that that you have spent so many crores on it in the past is
irrelevant no I have half a bridge is what I'm thinking what do I do with half a bridge okay so that's why you're going to complete it and you have a full useless Bridge instead of having half a useless Bridge how is a full useless Bridge better than a half useless Bridge right no I'm guessing there'll be some use out of half a bridge yeah the question is the amount of money you have to spend more additional money is it worth the some use of it that is the real question question right you understand the difference it is not how much you have already spent the additional money that you have to spend that has to be worth it and often it is
not okay so uh let me quickly bring this back to the example of stocks that you gave because I can I can make sense of it in the example of the movie that we started off with because if half the movie has been bad then will the other half of the movie be worth the time that I'm investing in that movie so if that is the only question that needs to be answered you don't have to to look at the previous half of the move but in in in context of the stock that I have I have already spent 200 bucks on the stock correct so now the question is will the stock rebound enough to cross
200 or is it going further down so the question boils down to the following right uh let us also take the case of uh taxes and transactions and so on right you bought at 200 it is at 180 right now if you sell right now you will make uh end up paying say uh 2 rupees tax on it so you will ultimately get 178 in hand okay okay if someone else came to you and told you that I'm willing to give you this stock for 178 huh today would you buy it knowing what you know today if the answer is no then the history that you bought it for 200 and I'm going to make a loss and then it might go up
again is irrelevant because every day you hold on to the stock is equivalent to you saying that I decide that today I am buying this stock at this price right that's how you have to think about sunk cost they're gone that's a very interesting way of thinking and it's not really intuitive No in fact that is the problem and that's why this episode uh exists by the way none of this is supposed to be advice in terms of dealing with stocks this is just an example of a stock you can replace the word stock with any other product we are not trying to give you stock advice or share market advice here there are way more qualified people
who will do that and you can look at them and speak to them but this is just an example of a product whose value is 200 bucks it just happens that we choose the word stock also I mean we do give stock market advice advice some once in a while and it is don't invest in stocks right just put in mutual funds you are not smart enough to make money on stocks and neither are most of the other people giving you advice but anyway coming back coming back so the sunk cost you're right it is very unintuitive and when you first find out about it it has an impact on you and then you start
noticing it everywhere in your life In fact when we were talking about this when in the prep for this episode we found out that anur himself has done this so we're going to invite anur and talk about his experiences with sun cost yes and how it was also nonintuitive for him it still is welcome anur so we are doing an episode talking about sunk costs today and I hear you have a lovely Story related to that yeah so uh this as we're talking in the lunchroom uh just a while back uh in 2018 or so we were struggling with one of our as businesses and uh we realized that hey uh we putting in like crazy amount of effort
to run this business but uh probably the right thing to do as in when I first heard about this sun cost policy it was basically basically a video by anur varu on L um and uh I saw that video like aost policy right so basically what was happening with your business is that it really didn't make sense to continue it but because you had spent so much money and effort on it you were sticking with it and when you found out from anur what Sun cost means you realized I need to shut it down yes so we decided to actually shut it down but got lucky to find a buyer for it and I can say I sold
that business as well but it basically like just calling someone and saying yes than okay so basically but now five years later you still know it was the right decision absolutely absolutely the right decision so I mean you know you saw I don't know if I'm allowed to say this here two or three years later that business they also rolled it up just the tech into whatever they wanted to use but the business serving the the segment of clients that offering they also discontinued the took them three years to realize their sunk cost yeah seems like but looks like you know you saw an episode on sunk cost and it changed how you look at things right yeah doesn't
seem like you have learned that lesson very well because I heard another example in the break room today okay yeah so I do tend to repeat the same mistakes it seems so I uh during the lockdown I since I was working too much from home I said hey I need a better monitor to work let me get an external monitor yeah and I went you know read some good articles said okay external monitor so I put up a 32 in external monitor there and uh um then I realized my laptop which was a old 2015 MacBook Pro does not really support this monitor very well let's stop at this point and viewers tell me what is the right
decision at this point okay think about it based on what you know about Sun cost now let's go back to anur what did you do so this laptop start to give problem so I managed to you know before it dies uh exchange it for uh new M1 uh oh no No in fact sorry let me tell you it gets more interesting yeah I exchanged it and bought a 15in MacBook Pro MacBook Pro yeah right uh one with a much better configuration and then I realized with this same 4k monitor that new monitor that new laptop makes a lot of noise yeah because the fans always go on think again after the second Point what is the
correct decision okay any come back to anur so I then managed to find a buyer for that laptop yeah and bought a MacBook M1 so the new Macbook Air M1 no fans no noise like highly rated but this one now had from 16GB I was coming to 8GB Ram yeah it started to struggle with this uh 4k monitor as well so I used it for a year a little over a year but with the 4k monitor I realized this 8GB Ram isn't working yeah so on Diwali I again found a deal within a year again within a year and a half this time to buy a M1 Pro this time and now it works great
with my monor yes but I'm now realizing that this laptop is a little heavy but I'm sticking with it so this is my fourth MacBook in like 2 and a half years because of a monitor 4k monitor so what was the ideal decision before buying all of these four extra MacBooks what we will leave that as an exercise for the motivated viewer okay thank youur thank you I still want to give a few more examples of some cost uh just to drive home the point please so um I mean you're married for 10 years and you're like very unhappy in the marriage do you divorce and move on or do you stay with it right I mean the the
effort that you have put into the marriage I mean you should really think of it as a sunk cost right so not enough people do that another is um a cell phone listen I don't think sunos fallacy should apply to relationships man I mean those are different game of okay yeah let's stick to money okay this was supposed to be financial decision so let's stick to money uh so you have a cell phone and the screen I'm still I'm still hung up on the relationships bit because I can understand why it would probably be some cause but at the same time I'm like no you have to put in some effort but then then it's like 10 years
you have put in the effort each one of you figure it for yourselves relationships some cost or not let me know your thoughts well at least you should be aware of what Sun costs are and how to think about it right and it's easier to think in terms of money and in terms of artificial examples okay so let's take an artificial example please so um I give you a 2,000 rupee coupon to a five star restaurant nice and it will get me a TI also I give you a 500 rupee coupon to a missile place it will get me lots of missile yes and then um you realize that both coupons are for the same date so you have to give up on one
of them okay also turns out just from your Expressions I can see you love Miss you're not going to like the food at that two five star okay so but 2,000 rup coupon at five star and missile which one will you go to I I personally would go to the missile yeah but they have done experiments on this and they have found that of around 57% in situations like this 57% will go with the more expensive place even then though they know that they're going to enjoy the less expensive place more why because our brains are weird right we just think oh I'm Giving Up on 2,000 rupee yeah I can I can see the financial aspect of
that thing why you would probably think uh that you're losing out on 2,000 Rupees worth of in fact this is much stronger if you bought the 2,000 rupee one and bought the 500 rupe one and then realize that one of them has to be given up right now it was real money that you were talking about that you had spent but the fact is that that money is gone correct right now whichever one you choose the amount of money that you lost Remains the Same so then will you choose the five star or the missile corre that's an interest see this is this is why this keeps throwing me for a loop because uh try as I might I can't
let go of the fact that I have already spent money on that because of probably because of the way I was brought up maybe something to do with the way I was taught to treat money that I I need to get full value for the money I have already spent correct and right the point is that if getting value for that money involves spending more money or more time or more effort right then you have to ask yourself is normally the way the normal World works is that if you have spent 100 rupes in the past then to complete something you have to spend 100 less and that's why our intuition tells us that you should pay attention to that 100 but
while you were spending the 100 if the situation changed and the amount you have to spend more is more than what you expected then you have to ask yourself forget the 100 that I spent this additional money that I have to spend is it worth it and even if it is not additional money I just remembered that we did an episode on the dollar value of time yes so time is also important time and effort so that that equation comes into Factor we'll put the link in the show notes if it is so let's take one more example right what what I'm basically trying to get at uh is that this is years and years of
conditioning that I'm trying to undo yes of course uh and it has that's why this episode exists in fact that's why all of future IQ exists to undo years and years of conditioning in your brain and uh in some cases or in this particular case it's like a million years of conditioning you will see all right so I'm not the only person to blame here so I'm happy but why does this even happen like yeah so they have stud scientists have studied this okay scientist study a lot of things yes uh teached they have found two or three interesting effects in our brain because of which this happens okay one is called loss aversion and the other is called the endowment
effect and I'll explain both of them okay l Aion let's begin loss aversion basically means that you know if you were to gain 100 rupees versus you lose a 100 rupees will the happiness from the 100 rupees that you get be roughly equal to the sadness you get from losing the 100 rupees no which will be more the loss the loss will be more I mean loss more than we get Fe let's take a couple of examples now this time I'm going to use artificial examples from the research studies to make sure you understand the point well this this example itself was very powerful 100 rupes gain versus 100 rupees loss the loss is infinitely more for example if
you go into an office right and there's a lovely mug right and you ask people how much are you willing to pay for this mug okay right of course what is the you know you come to some price that they'll say 100 bucks 100 bucks instead you go to that office give everybody that mug and now go around saying how much are you willing to take to give me the mug how much are you willing to sell the mug for yes and that number is not just as I mean normally if you were rational it it should be 100 right basically the mug is worth 100 that's why you paid 100 for it but once you have the mug H then you are
uh unwilling to part but wait they were given the mug for free yeah as in they got the mug yeah maybe for free or for 100 or for whatever yes but then they are not willing to give it up for 100 they need 150 or 200 or in some cases 250 to give up the mug listen I understand the concept of making a profit on it so if they bought the mug for 100 that's different no they were given okay they were just given so just you know the difference in the price of a mug you want versus that a mug you already have and you have to give it away is but they didn't even have the
mug forever they had it like doesn't matter that's the endowment effect once it is yours and this is salese use this very well okay if you go and you're trying to buy a car right first there'll be all kinds of things and various negotiations happen and then you say okay fine you have decided that you're going to take this car okay so the salesperson will go through a whole bunch of things to ensure that you know now you start thinking of it as your car okay and then they will start tacking on oh by the way there is this extra charge for this there is a this there is a that and so on if all of those charges were
told to you before you might have said okay I don't want this car I can't afford this is not worth it right but now that you have started thinking of it as your car okay the endowment effect kicks in I just realized I spent way more on my car than I should have ah and I literally did like I didn't need any of the bells and whistles that came added with my I genuinely didn't need correct so that that's basically the endowment effect endowment effect means when you have something you value it more when it is yours you value it more than when it wasn't yours in the first place that car wasn't even mine to begin with it was it
was it was already yours in your mind and that's what the salesperson was so basically you're going out to buy a car decide what you want before you walk into the showroom and talk in fact yeah that is one of the takeaways of this episode right but um L of version another uh example right uh and this is U actual uh research that was done okay people were given season tickets to the Opera okay costing $15 okay now oneir of them were just given that and told go ahead watch these operas okay one3 were given a $2 discount okay okay and one third were given a $7 discount on the original $15 okay so the money was
actually given back to them all of these people bought $15 worth of opera tickets but some of them got money back got a discount right then the researchers uh studied and saw how many of the shows were watched by these three groups would you like to guess what happened the people who got the $7 discount watch the most shows least least yes because you oh yeah they paid the least so they watched the least sorry correct the people who paid the most watched the most because oh you well you already spent $15 on it let's get the maximum value out of it right so I mean not only are you ours to losing money and your sunk cost and all
of that but the effect depends on how much uh the am reminds me of something really uh interesting that I heard once somewhere where someone said don't give stuff away for free if you want it to be valued yes yes absolutely absolutely so this this actually falls into the loss AV verion thing because once you give stuff away for free then the value of that in the person's head is zero correct which means they don't really have to recover any value on yes and um uh I'm trying to uh imagine if I can make both of them work with the endowment effect like like give something away for free and then make people value it by asking it back from
them that's actually an interesting sales strategy there's a whole bunch of things there right because uh they give you um something I mean some like a subscription where uh either it is a free subscription it'll start charging a little later or they give you discounts in the uh yeah they give you uh discounted prices for the first time or for six months and so on and then it start charging more and so on all of these are they want you to start thinking of this as something you have something you get used to and then losing it remember 1 GB per day free yeah that is what happened there yes so these are tricks they use all the
time man there are I I know for a fact that the advertising industry uses like a ton of these tricks and all of these are well researched psychological phenomena phds in Psychology get hired by Google and face Facebook for this reason behavioral economics there's a wellknown quote right which says that I saw the best minds of my generation spending all their Intelligence on trying to get people to click on boxes so it is true yeah it is true the brightest minds of our generation are working uh to make sure that you click on that ad that you're trying to desperately avoid yeah there we go so essentially what you're telling me is capitalism is to blame for all of this
nonsense that we are going through surely not right actually not uh this is fundamentally built into your brain and do you know how I know this how because it is built into the brains of monkeys also okay like you said uh it is not years of conditioning it is millions of years of conditioning so they did experiments with capuchin monkeys okay to look for specifically capuchin monkeys I think are Marcel from friends if if any of you watch the series friends pretty smart okay they are they are the capuchin monkeys they trained capuchin monkeys to understand the concept of supply and demand okay and the prices of things and so on okay I won't get into that today today I want
to talk about the fact that they checked out loss aversion and endowment effect on Capital uh on on on Capital monkeys capuchin monkeys okay so these monkeys had these little discs which uh were being used as money coins right and you could exchange a coin for a fruit or for a cereal okay right now there were two experimenters one of them used to show one piece of fruit huh and when the monkey showed up there this person with a 50/50 chance would put another second fruit there right so on an average the monkey got one and a half fruits there was a different experimental who used to always show two fruits H and when when
the monkey showed up just before giving the fruits 50/50 chance he would take away one of the fruit okay okay would you like to guess which of these two the monkeys preferred the first one first one even though both were exactly the same but in the first one you were gaining half of fruit unexpectedly in the second one you were losing half of fruit unexpectedly and the second is much worse okay uh that's there is a better way to explain it happiness is equal to reality minus expectations the expectation was you were going to get two fruits the reality was you got only one fruit most of the time or some of the time therefore happiness was
lower minus one yes correct so another how did they check endowment effect okay uh what they did was they adjusted fruit and cereal quantities to a point where the monkeys preferred them both exactly equally right half the monkeys preferred serial half the time same monkey half the time Cal in fact they adjusted it to the point where if you repeat the experiment 12 times half the time they would take fruit half the time they would take cial so now the experiments are sure that preferences are equal okay then they gave the monkeys serial okay and then they ask the monkey whether it wants to trade for a fruit okay you would expect that about half the time
the monkey should trade just for variety yeah 87% of the time they didn't 7% of yes right now you can think there's an explanation for this right uh explanation should be like you know why bother ugit kashala right I mean there's ugit kashala is a very marati phrase which is typically used a lot in Pune I can't translate it properly like I can't translate the sentiment of ugit kashala but if you can find someone who can explain if you can find a marati person who can explain ugit kashala to you please get them to do it you will enjoy it so just just to make sure that this is not because of inertia or uh
transaction overhead okay right they said okay fine we will give you a fruit plus a piece of oatmeal H and still the monkeys refus to exchange it okay in fact and to make sure how much oatmeal to give in a different experiment they tried different amounts of oatmeal to a point where monkeys were taking just the oatmeal in exchange for a coin okay so that so they ESS establish the values of the oatmeal the cereal the fruit so the oatmeal just the oatmeal by itself was worth it for the monkey to exchange with a coin so that piece of oatmeal and the fruit the monkey wasn't willing to exchange for the correct because now suddenly the
cereal which was equal in value when it wasn't the monkeys but now it is the monkeys and it's no longer equal in value monkey we have monkey brains in fact they said okay maybe you know just eating the cereal is easier whereas take the fruit and all that something effort might be different so they did the same experiment with walnuts okay there is a walnut inside a Shell versus a walnut that is already open huh okay of course the one inside the shell there has to be broken and eaten a lot of effort effort when you give the monkey a walnut with shell the monkey refused to in most cases major of the time refuse to
exchange it for a opened Walnut even though that gives you the same pleasure and less effort see this is when I'm different from the monkeys okay if you give me a walnut and if you then offer me an un an opened Walnut like a walnut without the sh I will go for the W without the psychologists at Facebook would like to disagree with you on this point and they have a list of things where you behave exactly like this okay I hate being called a monkey and more importantly I hate being proven that I act like a monkey so the point is I want to see the psychologists at Facebook I have some Choice words from them for in
fact uh what we see from ankur's case is that even when you know that this is going to happen it's still not easy to avoid it okay yeah um so I think the message to everybody is that what you said earlier with respect to the car figure out and write down your references Before Time okay and then look at that list and ask yourself why am I changing it right yeah um because uh the thing is that here this differen is between system one and system two okay if system two gets involved it knows that I shouldn't be doing this yeah but most of the time system one goes ahead and makes a decision and then
forces system to to come up with a good explanation for why am I doing this we've done an episode on System One versus system one of our earliest episodes go check it out we'll put a link in the description of course show notes yeah yeah so I mean you know what you want to know there are different people okay some are more system one thinkers some are more system two thinkers and system two thinkers are more likely to fall for these things oh sorry system one thinkers are more likely to fall for this understandably because your instinct is in this particular case the instinct is counterintuitive to what is actually uh the smart thing to do so I
can I can figure out I can imagine why so it would be nice for you to know whether you are a system one thinker or a system two thinker I thought all of us were system one thinkers by default well no no as in all of us are significant system one thinkers some are more okay and the good news is that not all psychologists are evil there are some good ones also so they have created an actual test called the REI okay uh link is there you should go check it out and see what the REI says about you if it says you are a more system one thinker than other people you should be more
more more careful or at least drag a system one to friend with you system to friend with you yeah fascinating man uh uh is there is there a way to train yourself to become more of a system to thinker I know it's a very weird uh question I don't know that but I can tell you situations in which this doesn't apply as much right one is that privileged people are significantly less lovers right which makes sense I mean if you have lots of stuff then losing something doesn't affect you as much as it would affect other people correct also it depends on the culture so I'm sure that some of this training can happen so they have done research and
they see that Eastern European people are more loss most loss hours whereas African people for some reason are the least loss hours right I can imagine them being you know happy gol lucky it's like don't worry be happy yeah but the happiest countries are in Scandinavia which is right next to Eastern Europe well that's a different issue okay happiness is just pretty much directly correlated to how much money you have okay but more money more happiness wait a wait a second wait a second there's something about endowment effect that I suddenly remembered it is completely probably unrelated but maybe also related uh do you remember the Monty Hall problem uh yes yes so does and we'll do an entire episode probably
on this later but just tell me in this in as short way possible does the endowment effect have anything to do with the choice required uh in the Monty Hall problem not really I think it's just more a question of that uh counterintuitive math counterintuitive math okay right all right we'll do an episode on the Monty Hall problem later meanwhile if you want to look it up please look it up we'll try and put links in the description but I don't want to spoil it for people who don't know about it and U yeah we we'll get back to that sorry you were saying um about loss aversion uh so I think basically uh I want to say that one find
out if you are a systems one thinker or a systems 2 thinker if you're systems one then be extra careful about these things even otherwise you should be careful okay find out your preferences ahead of time or take help of other friends to point it out uh to you okay help take friends to help you figure out whether you are uh you know falling prey to the sunk cost fallacy and live your life enjoy yes Shri na thank you future IQ thank you for watching till the end if you like this episode check out these others you might like them also and please share with your friends I'm sure they will also like these thank you