Cost doesn't determine value

By DAVID MOON, Moon Capital Management
March 19, 2006

A News Sentinel headline last week declared that the city of Knoxville could lose $5.2 million on a planned land sale to Sysco Corp. so the company can build a distribution facility. Ignoring the economic benefits of the 300 new jobs Sysco will bring to the area, the headline was misleading for another important reason: the city will not lose $5.2 million by selling the property to Sysco, even though the selling price is $5.2 million less than the city's $7.4 million investment in the property.

The city's cost to purchase the land and cap the contamination on the site is a sunk cost and is irrelevant to any potential buyer of the property. The city has already lost that money, even though the loss is realized only when the sale is complete.

Historic sunk costs are logically irrelevant in determining what actions to take in the present. The old Coster Shop property has a limited number of potential users and uses. The amount of money the city spent to acquire and prepare the property is irrelevant to the potential market for the property.

The notion of sunk costs doesn't just foul up real estate investors and newspaper headline writers. Stock investors succumb to it all the time.

If you buy a stock and the price falls from $30 to $20, don't let your initial purchase price affect whether or not you sell the stock. (This, and the other examples I use, ignore capital gains taxes. Taxes complicate the issue and may change your decision, but they don't change the concept.) The stock has no idea what price you paid for it.

It is irrelevant that you paid $30 for it. All that is important is whether or not you would be willing to pay $20 for it today, assuming you didn't own it.

It is common for folks to argue that they haven't lost anything until they sell it. Wrong. You lost the $10 when the stock declined. You just didn't create a taxable event by selling the stock.

But you say you don't want to sell the stock (or inner-city development site) until it gets back to what you paid for it.

The best way to earn your money back may not be the same way you lost it. It is possible that the price may never get back to your break-even point.

What would you do today, ignoring what you have invested in the stock to date?

I'm not suggesting that you should be biased in favor of quickly (or slowly) selling your losing stocks. The point is that your position of profit or loss is irrelevant to the relationship between the current price of the asset and its value.

Have you ever heard the real estate adage that you make your profit on a real estate transaction when you buy the property, not when you sell it? Despite what the taxman sayeth, the same is true for losing money.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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