Escaping a Bad Investment Can be a Terrible Burden

In the Financial Independence community, we have a dogged devotion to our investments. “Buy constantly and never sell,” and “you only lose money when you sell” are common refrains. When, then, is it acceptable to sell a bad investment? Should we hold onto investments which are objectively terrible, too? What about the emotional costs of an impossible decision?

The Sunk Cost Fallacy

If you run in personal finance circles for long enough, you’ll inevitably encounter the Sunk Cost Fallacy. When we make a bad or unfortunate decision and are determined to see it through to the end (no matter how bad it gets) because we can’t stand to write off the money we’ve already spent, we’re trapped in a sunk cost fallacy.

As an example, let’s say that early on in your journey to retirement, someone suggested that you buy a whole life insurance policy. Whatever the sales pitch was, it sure made a lot of sense at the time and you purchased a policy to the tune of thousands of dollars. Later, you learned that whole life insurance is rarely (if ever) a good investment. Because you had invested so much into the policy, you felt that you had to see it through rather than pull out what money you could and change course. The costs you had sunk into the investment made extracting yourself from it emotionally and financially painful.

Side note: a great many personal finance blogs promote whole life policies because, in a shock to no one, they are making a cut on referrals to whole life insurance companies. It’s a pretty decent barometer for determining the integrity of the blog, as those things go. The more you know!

My Bad Investment

Now you understand the basic concept of a sunk cost fallacy. It’s obvious that when you purchase a class of investment that is objectively awful, the best solution is to escape with what money you can as soon as possible, rather than allowing it to get worse and worse over time. As they say, the first thing to do when you are stuck in a hole is to stop digging!

The thing is, it’s a lot easier to sell a bad investment when your course change goes along with conventional wisdom. What happens when you have made a bad investment into an investment class that is good (or at least approved by those around you)? Allow me to use myself as an example!

Real Estate is one of my favorite ways to accelerate the journey to early retirement. I write a lot about it, and I really do believe that it has and will continue to play a huge role in our achieving financial independence. It may come as a surprise that even with my experience in finding properties that have contributed significantly to our goals, I still managed to buy a real stinker.

Several years ago, I bought a duplex in Cleveland, Ohio. I had found my property manager/realtor through networking on Bigger Pockets, and they introduced me to the market. This property management firm had a huge social media presence, moved a ton of investment properties, and from the outsider’s perspective, the market seemed active and vibrant. So, I jumped in on a property, and about a year later, a second one.

It wasn’t long before the cracks began to show. Rents collected would be reduced by arbitrary amounts, and the invoices that corresponded to the repairs were painfully vague– “resolve electrical issue,” “evaluate and fix necessary items as noted on inspection report.” I couldn’t tell what was going on, and because the PM had no online portal, everything always came as a surprise at the end of the month. I had no idea who had paid rent, when they had paid it, and whether they were in arrears. The in-house contractor’s father was the firm’s accountant, and messages to him went ignored or resulted in delayed monthly transfers.  The tipping point came when my concerns about the tenant’s use of water (for which I paid) were brushed off or ignored. I eventually ended up firing my first property manager and finding a new one.

The second property manager was more organized, with an online portal and somewhat clearer accounting practices, but I began to notice a new troubling trend: Trivial repairs were costing me far more than the same repairs would cost me in California! My suspicion was that since the tenants were working class and had limited incomes, the owner was seen as the profit center. As far as I could tell, the PM made most of their profits by artificially inflating the cost of repairs (and treating non-emergency issues as emergencies).

When I started to work with the second property manager, I had just closed on a new duplex property. The property was large and in decent shape. Though the costs of rehabbing both units as existing tenants left seemed too high, I justified it to myself by thinking that rehabs don’t happen too often, and that the initial investment would pay for itself once I had new, good tenants in the property.

I spent approximately 20% of my purchase price on the rehabs. Of note in a moment: one of the items included in the rehab was to add a shower to the bathrooms of each unit, which had to that point only had tubs. I allowed the property manager to select the contractor, and verified that they were licensed, bonded, and insured before I approved the work.

Eleven months later, I received a quote from my property manager for emergency repairs to bathrooms in both units. The quote was for nearly $9,000. Evidently, the showers that had been installed were cobbled together without adding a shower insert or waterproofing barrier of any kind, and in less than a year, both bath areas had rotted out and begun to destroy the floors and ceilings below.

What makes this even more galling is the fact that when shown the pictures of the shower when the work was originally done, I had called out the fact that the area had no waterproofing, and my property manager assured me that they would follow up and ensure that the showers were properly completed. Needless to say, that never happened. This is partially my fault– I should have continued to follow up doggedly, and I didn’t. When I demanded that either the property manager or the contractor be held liable and repair the faulty shower install, both balked. Neither accepted any responsibility for the damage, and my property manager refused to help with filing a claim with the contractor’s insurer. The PM had stopped using the contractor for work, they claimed, and so I was on my own.

It’s at this point that I felt one of the difficult parts of being a long-distance landlord: when it becomes necessary to take legal action, it is much, much easier to do so when you are physically present. Worse, I had already invested nearly $20,000 into repairs and rehabs on the property, and even though I managed to find another contractor willing to make repairs for half the original $9,000 quote, I began to wonder whether I was stuck in my own personal sunk-cost fallacy. I had another property in the same city that was doing fine, so why was I not able to stabilize this property, which was larger, in a better area, earned higher rents, and from all appearances was “better” than my other one?

Ultimately, due to a variety of factors (some of which I will need to discuss a few months down the line), I made the decision to sell the property, and I recently completed the sale process. Luckily, the property had appreciated somewhat in the time I owned it, and between the profit on the sale and the rents I did collect, I didn’t actually lose any money.

I have to tell you that admitting that I, a huge proponent of real estate investment, sold a property is very emotional and difficult for me. First and foremost, I advocate this type of investment to all of you in a very public way here on the blog. I don’t want to undercut a message that I still believe in very strongly. I feel embarrassment that things worked out the way they did. I really struggled with whether to explain all of this to you at all.

That said, I would be doing my readers a disservice if I was anything other than completely honest with you.  Even with the best possible analysis and a theoretically “good” property, it’s possible to make a mistake, or at least to end up in a situation where you don’t want to commit the money and time necessary to weather particularly difficult times.  In my case, it’s a little of each of those things.  My life is changing a lot now and in the next year. When I asked myself whether this was a problem that I wanted to take on, the only honest way I could answer was “no.”

Another reason that it’s tough to make a decision like this is that we as a community are extraordinarily “sell averse” when it comes to the investment types that the community approves of. Real estate and index funds generally receive a blanket “buy and never sell” advisory. Selling, even under the best of circumstances, can evoke feelings of shame and frustration. I know, because I experienced them in this case.

How to Determine When To Sell

You may see yourself somewhere in this article. Maybe you made a bad investment that it took you a while to escape. Maybe you felt that you had to hide the fact that you sold because of pressure from the people around you– be it the FIRE community or family members with strong opinions. Maybe you felt weak because you couldn’t or didn’t stay the course.

If we sold our investments any time they experienced a loss, nobody would ever make any money! I asked myself the following three questions (and bounced a lot of my thoughts and feelings off of my wife) before I made the decision to sell my rental. I hope that they may help you should you ever face a similar decision.

1. Do I need what remains of the principal investment right now? This is probably the most common reason for people to “sell low.” A tax bill comes due, an emergency that surpasses your emergency fund occurs, or another unavoidable expense is incurred. You don’t want to, but the only semi-liquid asset you have in order to meet the expense is an investment that is, at the moment, performing poorly (or even well). Contrary to some FIRE adherents, I want to tell you that I don’t believe you should feel shame here.  It’s ok. Had you not made wise financial decisions in the first place, you wouldn’t have this flexibility. Being able to overcome an emergency, even if it’s unpalatable, is exactly what you’ve been saving for. In my case, I did not immediately need the funds I had invested in the property.
2. What are the realistic chances of this investment becoming profitable within a reasonable time period? As objectively as possible, write down the steps that are necessary (this may be “do nothing and wait for xx months/years”) to get your poorly performing investment back on track. If the string of events is too implausible (or too reliant on luck) to return to profitability, get out. Also, weigh the probable performance of the investment’s value in another asset class. Would it be easier and faster to simply reallocate the value of the investment into index funds/another property/whatever versus an indeterminate amount of repairs and property manager changes?  In my case, the answer here was “yes.”
3. Do I have the financial and emotional resources to return this investment to profitability? Though this is a more subjective measure, it is as important as any of the others. We all are limited in how much money we can allocate to the maintenance of a poorly-performing asset. We also all have what I call an “emotional reservoir” from which we take energy to address challenging situations, and a bad investment can drain this reservoir– fast! It was this question that ultimately sealed my decision to sell my rental.

These criteria were invaluable in helping to make the decision to sell my property, and in helping to come to terms with the negative emotional burden associated with it. Though I felt that I had the money to continue making repairs and to change property managers again, my honest assessment of myself was that at this moment in my life, I simply didn’t have the emotional resources and time to address the needs of the property. We have a baby on the way, a lot of upcoming expenses (we’ll explain in the coming months), and my emotional reservoir is already stretched thin– not yet dangerously thin, but thin enough that for the sake of my mental health, I felt that the money was better allocated elsewhere. Simply wanting an investment to turn out well– however desperately one wills it– does not make it so.

If there’s one message I’d like to get across with this article, it’s that shame, even when you have to make an investment decision that you find distasteful, is unnecessary. We are all financially imperfect, and it is our progress towards our goals– not perfection– that determines our ultimate financial success. We should work hard as a community to remove feelings of embarrassment from decisions borne out of necessity.

Have you ever experienced negative feelings from the sale of an investment? Did going against the conventional wisdom of this community (or any other) ever weigh heavily on you?  How did you ultimately decide to sell an investment that you desperately wanted to turn out well? Let me know in the comments!