Most investors know investment prices move up and down over time. However, many investors panic when things get tough and make investment decisions that are opposite of what should be done. With the current worldwide dramatic fall in prices of so many investments (stocks, real estate, etc.), emotions can be even more dramatic resulting in many people selling (and buying) at the wrong time.
Seasoned investors count on fear driven selling
In a previous post, I wrote how professional investors count on panic selling by unseasoned investors to determine good buy points (click here to read the article). Usually during very heavy sell volume days when prices drop dramatically for a stock, that is the point that the price starts to turn around as most sellers finish selling their shares. At this point the professional investors know they can get a rock bottom price when buying into the investment. However, in this market, there is no assurance the low price won’t get lower in the near future if these buyers also begin to sell through even lower prices.
Remember a loss is not real until you sell the investment
It is scary holding one or more investments where the price has dropped 40%, 50%, or more just in the past few months. If you have continued to hold your dropping investment through this downturn – whether it be stocks, real estate, or other investment – remember you have a paper loss until the investment is actually sold. As an example, if you have a rental property that was previously worth $250,000 and is currently worth only $150,000, it can be very tempting to sell the property for fear of even lower value in the future. If you don’t sell, then the perceived loss of $100,000 ($250,000 past value – $150,000 current value) is not realized. Only if you actually sell the property will there be a $100,000 loss in value.
Commenting on a recent article on CNN
This past week money.cnn.com ran a story on a young couple who have done a good job saving and investing money. The story can be found at: http://money.cnn.com/2009/02/18/retirement/makeover_savers.moneymag/index.htm. Financial advisors provided thoughts on whether the couple should make changes in their saving/investing strategy based on losses experienced with the recent downturn in stock and real estate values. One of the recommendations was to sell the rental property this couple has that has a $400 per month negative cash flow over rent. The sales recommendation is not necessarily based on fear, but was suggested to free up the $400 per month for use in other after tax investment accounts.
That recommendation really bothered me since this couple is in their late 30s and don’t plan retirement for 20 more years. In my mind, they have many years to wait for the real estate value to recoup the $100,000 drop, while collecting rent all the while to pay down the associated mortgage. After 20 years, the mortgage will be largely paid off and the monthly income from raising rent over those years should have erased the $400 negative. Since the property was bought in 2006, they would only have seven years left on the mortgage. Even if they do retire in 20 years as planned, holding onto the property seven more years to pay off the mortgage would provide a nice rental income to use for whatever purpose they needed during the rest of their lives. Hopefully, the value has grown over all of those years as well to increase the value of their estate as an added benefit for the heirs.
Assume they sold the property out of fear
For purposes of discussion, let’s assume this couple was getting very nervous about the perceived $100,000 drop in property value and sold out of fear of losing even more. In that case, they would miss out on the scenario I provided above where eventually the property could be debt free with a large cash flow going into the couple’s future retirement needs. If the couple had a mortgage on the property higher than the current $150,000 value, then the couple would owe taxes to the IRS on the difference between what the couple owes on the property and what the mortgage lender was able to get paid back from the sale. The IRS treats this difference as income to the owner. This all assumes new tax laws are not implemented as part of the stimulus package. Check with your tax advisor if you are in a similar situation before taking any action.
In this case, fear would prevent the couple from enjoying the benefits of owning the rental property as I outlined earlier. The couple could potentially owe a large tax to the IRS on the portion of the mortgage loan that was not paid off from the property sale. They would add shame and a sense of failure to their self image, likely keeping them from considering other potentially good investments in real estate for fear of losing large amounts of money again. The loss of self image and lack of confidence in their ability to chose investments could lead them toward investing only in safe assets like CDs or even savings accounts. Those investments will lose money over time as inflation eats away what money they do have saved. All of this because the couple sold, rather than rationally thought through that there isn’t really any loss unless the property is sold. Even though you should mainly focus on buying rental properties that have a positive cash flow from the beginning, in this case, the loss is only $400 per month against their combined income of $250,000 per year. That, to me, makes no sense to sell with the added costs that could result from selling the property vice the monthly loss of $400.
These consequences of fear selling apply to other investments as well
Personally, I sell stocks when I first see technical indicators showing a down term coming. However, if you have already ridden down the price drop without selling and are scared of losing more, sit back and take a breath. Look at the reasons you bought the stock – hopefully rising market share, increased net cash flow, etc. If those same indicators are still valid, then think twice about selling into a significant loss if the stock should have a good chance of making up the loss over the next 5 or 10 years. You need to consider each stock on its own merits. Of course, there are many stocks where the fundamentals have changed dramatically for the worse where they no longer have any prospects of increasing income or market share, etc. In that case, you may need to sell now to prevent even further loss. All I ask is that you don’t sell out of fear. Look at all the information you can get on the company. Look at how much debt they have on the books and how likely they are to pay off those debts to remain profitable. Look at the industry the company is in. Is the industry one that is being hit and continues to be hit seriously? Make your decision based on facts, not on emotions of the moment.
Don’t play into the hands of seasoned investors who count on the inexperienced investor selling at the worst possible time, handing these seasoned investors potentially great bargains. Many of these seasoned investors make this part of their investment strategy to wait for the panic sale periods in the market before making purchases. Imagine if you were patient enough to wait for these periods of uncertainly to build a portfolio of investments at very good prices. Now imagine how much money you would have when the markets then recover and grow beyond where they were before the market fell. You would have bargain priced investments with strong growth over time. It is like looking for fire sales at the store before making your purchases. It builds your self esteem and reinforces your confidence as an investor. Learn to control your emotions and invest based on facts to increase your long term prospects for success as an investor.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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