Use This “Accounting” Idea to Become a Better Investor

One of the classes I had to take in college for my accounting degree was Managerial Accounting. The class taught us how to measure and analyze manufacturing costs for individual businesses. If an accountant (or entrepreneur) miscalculates these costs, the business stands to lose a lot of fungolas (the word Gary Halbert used for money).

You may think you’re making fungolas when the reality is you’re losing fungolas.

This class was probably the most practical course I had throughout my four years of college. There’s one concept from this class that is critical for you to understand and apply to make better investment decisions.

And I should issue a warning with regard to this concept… it’s not easy to apply because of how we’ve all been trained to think about investing.

The concept is referred to as SUNK COST.

A Sunk Cost is a cost that has already been incurred and cannot be recovered. After you make an investment, the price you paid for the investment becomes meaningless. It’s a sunk cost because the money is gone, and in most cases, cannot be recovered for the same purchase price.

As an example, let’s say you buy 10 shares of Amazon stock at $2,000 per share for a total investment of $20,000. Once these fungolas leaves your account, you need to forget the $2,o00 share price. By ignoring the share price you paid for these shares, you actually make better investment decisions.

You’re forced to evaluate your investment with current market values. If the market value of Amazon drops to $1,600 per share, you’ve got to ignore the $2,000 you paid because it’s a sunk cost.

You have to decide the best course of action with your Amazon shares based upon the new $1,600 market value. This makes sense intuitively; however, we don’t think this way normally.

When we look at this investment, we are trained to see the $400 (per share) loss. We tend to make all of our decisions around the initial $2,000 purchase price, which is actually irrelevant.

The best strategy when evaluating any investment is to focus on the current value, not the price paid. The price you paid is a distraction. Understand this sunk cost occurs in EVERY investment.

If you buy a single-family rental property for $100,000 and the real estate market crashes, taking the market value of this home down to $60,000, the same idea applies.

You have to make decisions for this asset as if you paid $60,000, not $100,000. The $40,000 of lost value is gone and it’s just a distraction that will impact your decisions with regards to this investment.

By the way, this is actually what happened here in the States back in 2008. Many investors, including myself, focused on the price we paid for our real estate investments even though these prices became sunk costs.

We focused on the original price and ended up selling our properties (short sale/foreclosure) at the bottom of the market. This was a very costly mistake for many investors. The best investors ignored their purchase prices and made decisions based upon current values.

They asked themselves if they would buy the same asset for $60,000 now. If their answer was “yes”, they kept their real estate investments. If their answer was “no” they wouldn’t buy the same asset at the lower price point, they sold the property.

My BIGGEST investment mistake was buying an 8,000-square-foot commercial building in a depressed area. I paid $550,000 for the property at the top of the market. When the market crashed, the value of this building dropped significantly because we lost three long-term tenants. There was zero demand for commercial office space in this area, and the building was hemorrhaging cash. The mortgage payment, property taxes, insurance premiums and ongoing maintenance expenses were killing me.

After a few years of dealing with this, I happily sold the building for $125,000 in a short sale. When I drive by this property, a big smile instantly appears because I no longer own that horrible investment. That was my favorite real estate sale and I lost a lot of money! LOL

I wouldn’t buy that building today for $125,000. Hell, I wouldn’t buy that building for $100 because there’s still no demand for office space.

On a high level, as Cashflownaires we don’t invest for appreciation so our purchase price of an asset really doesn’t have much impact on our decision making process. We invest for cashflow, and because this is our focus, we make decisions around future cashflow.

Will the future cashflow of this asset be attractive?

If the future cashflow will be impaired for any reason, sell the asset and take your loss. Move on to a better income-producing asset. The price you’ve paid for the asset really shouldn’t be part of your analysis!

Yes, this is easier said than done!