Oct 09

The sunk cost fallacy – lessons from poker

Poker isn't the only place we chase 'sunk costs'

Lesson from poker in loss aversion

Poker might not seem like the obvious place to start when it comes to learning about saving money. But it is a great showcase of human behaviour.  The best poker players know two things; statistics, and not to chase sunk costs.

So you’re playing Texas hold ‘em. You have your two cards in the hole, and the dealer lays out the flop, the first three communal cards. It’s looking good, a potential full house. So you start to bet, feeling reasonably confident. However, as the next card come down, with its own round of betting, it looks like someone could get four of a kind or a straight flush. A hand that’s going to beat yours. But you’ve still got a good hand… and there’s a lot of chips in that pot now.  And so many of them are yours!

A good poker player, all else being equal, would know it’s time to fold, as tempting as all those chips may be.

They have analysed the odds of winning the hand, and is only considering his future costs against his chance of winning. A bad poker player is suffering from loss aversion and goes chasing them chips!

Loss aversion is a well-studied psychological phenomenon that shows people prefer to avoid losses even more than they like making gains (it’s even been shown in monkeys!)

It’s likely this phenomenon that leads to bad poker players, and people chasing sunk costs.

Sunk costs are costs that you have already incurred, and have no way of recovering them. The problem is when loss aversion encourages you to spend more in order to justify the original spend.

Let me give you an example. I once booked a meeting room for training. Our current meeting room was not going to be large enough for the whole company so we needed the extra space.

However, on the day, a critical client meeting came up, someone called in sick, and for various other reasons people couldn’t turn up. This meant that we could now fit in the meeting room at work. However, it was decided that we should still use the external meeting room, since it had been paid for, and it was too late to cancel and get a refund.

It was, of course, a sunk cost. Chasing it incurred further costs: the travel time, multiplied per person, the price of the coffee etc.

The smart thing to do would have been to leave the room unused and hold the training at the office. It’s all too easy to hang in there for that last card. As Herbert Yardley  said, “A card player should learn that once the money is in the pot, it isn’t his any longer”.

The same can be said for money identified as being a sunk cost – it’s not yours anymore, don’t go chasing it.