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Beware the sunk cost fallacy in a post-pandemic world

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As we emerge out of lockdown into a post-pandemic world, Kevin Philips considers what this means for the economical future of business and industry.

5th May 2021
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I live in a city that, in years gone by, was a major tourist destination for local and international visitors, especially during the summer months. Inevitably, restaurants would hike prices at this time of year, and, certainly, demand was high. The city was busy, people were in a holiday mood, end-of-year bonuses had been paid, the exchange rate was favourable, and waiting lists for tables were long.

But, come the end of summer, all too often these tourist prices would remain. And each year you would see the same thing happen: the go-to place for the last season or two would disappear after a few slower winter months. These typically were the restaurants that would hang on to that festive season premium, instead of adapting to a changed situation. On the other hand, restaurants that acknowledged their local, all-year-long clientele with winter specials typically stayed around, year after year.

It seems like we face a similar situation now, as a post-pandemic world slowly becomes a reality. While currently many commentators seem bullish about a fast post-pandemic bounce back, and even boom, this is unlikely to be consistent across countries, industries, and population groups. Just as the pandemic affected different groups in different ways, the recovery is likely to be patchy, depending on vaccination schedules, for a start.

Will industries that boomed during the pandemic, for instance technology, home improvement and home delivery services, maintain their trajectories, see a correction, or experience a crash? Further, what will the recovery for industries that were decimated by the pandemic, such as travel, look like? In both cases the world has changed substantially since 2019, and as I’ve written previously, using recent data as a predictive tool should be treated with caution.

The sunk cost fallacy

Today, at an individual company level we each have a choice to make as we consider our post-pandemic strategy. Do we succumb to sunk cost thinking and try to make up our pandemic losses quickly? Do we cut costs, raise prices, gouge our customers, and exploit our people?

Or do we take the approach of treating what has gone before as history, and what is in front of us as a new paradigm that requires a fresh outlook? With this approach, we ignore retrospective costs as no longer relevant in our decision-making. They’re water under the bridge and to take them into account means we misallocate time, effort and resources going forward, because we are factoring irrelevant information into our decision making. Economists agree that avoiding the sunk cost fallacy is the rational approach to take.

An example of this approach is the stock market. Do you stick it out with an under-performing share in order to hopefully recoup your losses? Or do you write-off your losses on that specific share and redeploy your funds on better performing opportunities where you can not only recover your initial losses, but also see additional future growth?

This highlights the second downside to sunk cost thinking. Not only does it involve acting on irrelevant information, it comes with a massive opportunity cost. If we are so fixated on looking backwards and recouping our losses, we miss out on the opportunity to explore new growth opportunities looking forward by changing our approach for the current reality and areas of growth. You could summarise this as the difference between an austerity mindset and a prosperity mindset.

Travelling forwards

Take the travel industry. Undoubtedly it was one of the hardest hit sectors during the global lockdown. But once the pent-up demand for travel is unleashed, the industry will no doubt experience a very welcome upswing. And as with my local restaurants during winter, these businesses have a choice: write off their losses and look to the future to grow a thriving business in the long-term, or, make their first visitors pay for the losses over the past year.

Starting with a clean slate and resetting our mindset enables organisations to react to today’s circumstances and today’s customers’ requirements. This is not that different to how a salesperson starts each year — the counter goes to zero and targets are reset. This approach takes a realistic look at upcoming costs and the potential for sales, looks at what the product is worth, and sets targets and pricing accordingly and realistically. To be sure, to do this you need your finger on the pulse of your organisation, with real-time insights into trends, predictions, and expectations relevant to your current circumstances.

Perhaps this rational, prosperity mindset will become a self-fulfilling prophecy, driving growth today, tomorrow and into a possibly uncertain future.

Replies (7)

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By Hugo Fair
05th May 2021 14:46

Economics has got a lot more exciting than in my heyday if "Economists agree that avoiding the suck cost fallacy is the rational approach to take"!

BTW the fallacy component is based on "At any moment in time, the best thing to do depends only on current alternatives; the only things that matter are the future consequences; past mistakes are irrelevant" ... with particular emphasis on that final phrase.
People that take on board the dictum have been known to 'throw the baby out with the bath water' (i.e. treating everything from the past as irrelevant - whereas plenty of the past will still be highly relevant to the present and the future).
The trick is to have a clear mind and not be blinkered by whatever management fad comes along.

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Maytuna
By DJKL
05th May 2021 23:44

"An example of this approach is the stock market. Do you stick it out with an under-performing share in order to hopefully recoup your losses? Or do you write-off your losses on that specific share and redeploy your funds on better performing opportunities where you can not only recover your initial losses, but also see additional future growth"

Conversely chasing the new bauble may blind you to what you have, you observe your loss and consider the grass is greener, but this has an inbuilt assumption that you now know where the greener grass grows, why should you have that ability now if your past pick was a mistake (and it may or may not have been), why back your skills that have previously failed to now choose a different allocation of your resources?

What you ought to do is forget your entry price and place a value on your investment given the new environment you observe that will impact it, in effect redo the calculations you would have done were you standing with cash on the hip uninvested deciding whether to invest.

Markets over react on both the upside and the downside, given analysis of stockmarket price movements suggest most of the annual gain on a share is made on very few trading days in the year, flitting from one thing to another can be a recipe for losing money.

LTBH performance , if you buy quality in the first place, is hard to beat.

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Replying to DJKL:
Kevin Philips IDU
By Kevin Phillips
07th May 2021 09:13

100% the point I was getting at is there is a tendency for some to become blinkered by an under-performing stock in the portfolio and not take the clean view as to where you are now and what the future holds, not dissimilar to your "cash on the hip" analogy. at any point in time one should view the value as it is and what can be best done with it the concept of holding until you break even just holds back and limits your options.

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Replying to Kevin Phillips:
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By Justin Bryant
07th May 2021 17:19

But DJKL has pointed out that your point above is obviously wrong (before I read his comment I was going to make the exact same point as him), since it implies you can correctly predict the future movement of share prices based purely on their past performance.

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Replying to Kevin Phillips:
Maytuna
By DJKL
08th May 2021 15:44

But to employ the very little Latin I still remember, one also requires to festina lente.

The most difficult skill to master ,imho, is doing nothing, forcing yourself to sit on your hands, give markets time to sort themselves, despite perfect market theories these may only operate over the longer term not the shorter term.

When younger I was as guilty as the next person in seeking instant gratification, it is underperforming, x could do better (omitting x could actually do worse), I learned over time by experience and from my father that reacting is often the worst thing one can do. (this rule also applies to meetings, dealing with one's kids etc, deliberation, measured, ponderous actions often tend to work to one's advantage)

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By flightdeck
06th May 2021 10:39

Excellent article.

It made me think of blockbuster and netflix. We all know the outcome and I have often wondered what I would have done if I was Blockbuster's CEO. I could big myself up and say "well of course I would have put money into a streaming service" but would I? Hummm. They had 9000 stores. Would you have stood up to your board and shareholders and investors and said "Yeah, I know. Anyway I'm done with that, gonna close it all down and just going to be a web service".

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Replying to flightdeck:
Kevin Philips IDU
By Kevin Phillips
07th May 2021 09:15

good example, it would have taken a lot more courage than most CEO's have to make that call to the board! :)

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