Knowing when to fold ‘em when it comes to investments
AS THE great Kenny Rogers wrote, " ... you gotta know when to hold them, know when to fold them, know when to walk away and know when to run".
No-one likes losing money on an investment, but it happens to everyone at some point, even the most experienced investors. So what should you do when you discover you have made a bad investment?
The approach I hear a lot from people seeking my guidance is something like: "I paid $X for the (property/shares/ostrich farm), I need to sell it for at least that." There are number of fundamental problems with this approach, however.
Firstly, the investment is only worth what the market is willing to pay for it at any point in time. What you bought it for is irrelevant. As are the renovations and improvements along the way. These are sunk costs. This can be hard to accept but it is unavoidably true. The tendency to retain and even continue investing in a loss-making venture is human nature because none of us like accepting failure. However, all that is relevant is achieving the best outcome looking forward.
Secondly, it ignores the time value of money. As most people appreciate, a dollar today is worth more than a dollar in five years' time, because of inflation. So if you paid $120,000 for an investment two years ago, it is currently worth $100,000 and is likely to be worth $120,000 in two years' time, should you sell now or wait two years? The answer is ignoring what you paid for it, what is the "net present value" of the future $120,000 - taking into account your cost of capital or "discount rate" (ie, the return on a similar investment you would invest in). If that is, say, 8%, then the value of the $120,000 in today's dollars is about $102,000.
Therefore, if the prospect of getting a price of $120,000 in two years is certain, you should hold on and sell then. However, what if the future price isn't certain? If historically the average capital growth in the market for your investment is 5%, then the probability of a 10% return in two consecutive years may be low. With only $2000 the difference, any result less than $120,000 would make cutting your losses and selling now the better decision.
If the investment is negatively geared and net cashflows of, say, $2000 a year, after tax, accounted for, even a certain selling price of $120,000 in two years would provide a worse outcome than selling now.
Understanding basic financial concepts such as the time value of money and sunk cost can help you make better investment decisions. If you would like more information on how to apply these concepts in practice please drop me an email at Campbell.Korff@ybr.com.au