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Sunk Costs and Investing

People often ask me for advice about what to do with an investment that has performed poorly. Other times, people tell me that they’ve been convinced of the benefits of index funds, but they’re reluctant to sell their current holdings that have decreased in price because they don’t want to “sell low.”

My suggestion is usually as follows: Imagine that the entire balance of your account was currently in cash (rather than invested in whatever assets it’s in at the moment). How would you go about investing that cash? If you would not buy whatever it is that you currently own, then you shouldn’t be continuing to hold it.

It’s the exact same thing as the sunk costs concept. How an investment has performed in the past is not what matters. What matters is that you put together what you expect to be the most appropriate portfolio for your needs going forward.

Possible Exception: Taxable Accounts

Of course, the above analysis assumes we’re dealing with tax sheltered accounts like 401(k)s or IRAs. In the case of taxable accounts, selling one investment to buy another may have adverse tax consequences. Not that that means you shouldn’t do it; it just means that you must weigh the pros against the cons.

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Comments

  1. I think the other sunk cost that trips people up with investments are loads. If you pay a 5% load to buy a mutual fund, that money is gone, whether you keep the fund or change to a no-load index. There is no actual way to hold a fund long enough to recoup the load.

  2. Too true. I’ve seen that exact error in reasoning come up very frequently.

  3. Rick Francis says

    Mike,

    I agree with the sunk cost analysis, however it strikes me that if a person shifts all of their investments at once they are effectively timing the market. Wouldn’t a more gradual shift over a year or two say selling off non-index funds during rebalanceing be less risky?

    -Rick Francis

  4. Rick: You’re right: It certainly could be. It depends upon how drastic the change is. For instance, I wouldn’t worry the slightest bit about moving from an actively managed large-cap blend fund into an S&P 500 index fund all at once. On the other hand, if the investor’s overall asset allocation was going to change dramatically, it could well make sense to do it over time.

  5. I agree with the sunk cost concept.

    The position is worth what it today and there’s nothing you can do about that (unless you are a bank and some small group of accountants tells you that you don’t have to mark to the market).

  6. For somebody with a long investment time line (30+ years) does it really matter if the investment is performing poorly right now? Wouldn’t I actually benefit by being able to purchase shares at a lower price?

  7. Dave C,

    Yes, you can buy shares and pay a lower price.

    But that is not relevant. You can buy those shares at today’s price – even if you had not bought any shares earlier. You are currently losing money on that original trade, and no matter what your time frame, that is not a good thing.

    Wouldn’t you be better off if you had not bought those original shares and invested twice as much cash today?

    The people who tell you that current price doesn’t matter don’t grasp the concept. They believe that if you are not exiting the position, it does not matter what the value of that investment is. Don’t fall for that.

    Here’s what is true: There is nothing you can do about the fact that the price is lower. There is no need to shed tears over a trade that is losing money. Your decision is: Do you still want to own shares of this entity? If yes, continue to buy.

    Obviously you have two conflicting hopes: a) You want your shares to be worth more in the future; b) You hope to buy lots of shares at what turns out to be a relatively low price.

    You have no way on knowing what will be a low price in 30 years, so if you want to steadily invest, do so. But just because you are not cashing out today does not mean that you shouldn’t care about the price. After all, if the stock price doubles over a short period of time and you cannot figure out why that happened, then you may decide this investment is now too overvalued and get out.

    It’s not that you are timing the market or taking a quick profit. It’s that you would rather own a different entity or different asset entirely – one that your research tells you is more fairly valued.

  8. Thank you Mark, that is a great explanation.

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