Pete Carroll, head coach of the NFL Seattle Seahawks just made a controversial decision. His starting quarterback will not be Matt Flynn, the expensive free agent pickup. Rather, it will be Russell Wilson, the unproven Wisconsin rookie they drafted in the third round of the 2012 draft, because he wasn’t a “classic NFL” type of quarterback like Andrew Luck.
A third rounder doesn’t get paid much (relatively speaking, of course) and Flynn has a $20 million contract, of which $10 million is guaranteed. Conventional wisdom says you don’t pay someone $20 million and then have him warm the bench. Carroll, when asked about this, he replied that he does what he needs to do to get the talent, but he doesn’t let the price of the talent dictate his decisions going forward – only performance.
In other words, he only looks to the future. When it comes to investing, this is a lesson all of us can learn from.
Let’s say you bought a rental property, stock portfolio or mutual fund, and it has gone down in value. You think it will go up again at some time, hopefully soon. Do you hold on to it, or do you take your loss and move on? I don’t know of any polls on this issue, but my guess would be 75% or more of us do the “hold on and hope for the best” thing.
Is that the best approach? In a word, no.
It might feel the best, and when the investment turns around, you might feel vindicated in your original choice, but is it the wisest decision? Not if there’s a better way.
There is. It has five steps.
1. Convert to cash.
The way to look at the decision is to mentally convert everything to cash. Let’s say you bought for $25,000 and it’s now worth $15,000 (ouch, I know). From now on, you will only think of the cash, never of the previous investment.
2. Forget about the past.
Like Paul in Phil. 3, we need to forget the past and not let it cloud our decision about the future. It is what it is. And it’s all turned to cash now (in our minds at least).
3. Now look for the best investment.
If you had $15,000 in cash today, what would be the best investment you can think of? When your starting point is cash (forgetting all things which are behind) it’s amazing how much clearer we can think about the question. All you’re considering now is the future.
4. Now forecast your current investment.
If you had $15,000 in cash and invested it into what you have at the moment, what is the most realistic outcome you project?
Now it’s a straight up comparison, isn’t it? Your thinking is beginning to crystallize. If at this point your current investment is the best option you can come up with, your decision is easy: hold on.
If not, there is one more step before exiting your current asset.
5. Now look at transaction costs.
If you need to sell a property, what are the commissions and other costs? If you need to sell mutual funds or stocks, the costs are probably a lot lower. What are the tax implications? In other words, if you were to exit your current position, how much cash will you really end up with?
Your net amount to invest will be less than $15,000 in our example. Now, calculate your expected return on the new investment and compare it with your earlier projection of your current investment. The fact that you have no transaction cost on your existing investment might make a difference, especially if it’s real estate. Most of the time it doesn’t, but it is important to check.
If the best other option still looks better, sell what you have and buy the next thing.
In logical terms, this is half easy, but not totally easy. Emotionally, though, it’s a lot worse. There is something in us that just has a hard time admitting failure. We strive for vindication, and often are prepared to endure losses to get it. And yet, even Warren Buffett has had his share of failures, but he had more successes.
The key to long term success is having the discipline to know when to cut your losses and let your capital return more from a different investment. It is one of the benefits we have: we can cut our losses short, and let our gains ride as long as we want to.
In the last recession I learned the value of this approach. Like most people, I had some investments that got clobbered in the great crash, and I forced myself to take stock and look at my portfolio from this perspective. I ended up selling everything and went with stocks I believed were clobbered even harder.
My previous investments all came back, and if I had kept them, I would have felt good about it.
However, the stocks I bought did way better, and I ended up making double with the new picks than I would have if I followed my heart and went for vindication, rather than profit.
Pete Carroll says let’s go with the option that gives us the best chance for future success, without consideration of the past.
What would you do if your investment portfolio was cashed out today? Have you taken the time to scout out the best possible option?
William Cowie is a retired businessman who blogs at www.dropdeadmoney.com, where he offers a free guide on how to benefit from the economic cycle, whether it’s going up or going down.