Suppose Bob has $15K invested in an account with 2 funds (for this question we'll assume a Canadian RRSP, but the country/tax implications probably aren't relevant).

He has $10K in a conservative balanced fund (let's call it Fund #1) that historically averages 6.5% per year return, but can fluctuate. For example, in the crash of 2008 it lost 12%, and in the recent volatile market it has also been losing about -1.5%. The MER (Management Expense Ratio) for the fund is also relatively high at 1.85%, so unless the fund makes more than 1.85%, Bob loses money on it.

Bob's remaining $5K is in an ultra-conservative short-term income fund which has never lost money year over year. Fund #2's historical average return is 4.5%. Bob is not terribly risk averse, but he's in this fund because he anticipates an upcoming major home repair and wants to keep the money safe while enjoying some meager gains. The MER on this fund is a much better 1.15%.

Bob has set up a $250 monthly payroll contribution to his investments. All new contributions are going into Fund #1. Bob is happy with this long-term plan.

This morning Bob calls his account rep and requests a one-time withdrawal of $2000 because he needs the money for something important. Bob asks to withdraw from Fund #1 because it is not performing well. He believes the market will be volatile for the next little while, and wants to use this as an opportunity to reduce his exposure a bit. Also, he wants to keep Fund #2 at $5K for that anticipated future expense. To Bob's surprise, the rep advises him to do the opposite: "Withdraw the money from Fund #2. You have already lost recently from Fund #1, and if you reduce it now, you'll never gain back that loss. Long-term, this is the better strategy."

Bob replies: "What I have lost in the past is irrelevant. I only care about the safest strategy going forward. I can't predict the future, but I'm pretty confident that for the next few months, my money is safer in Fund #2."

Is Bob getting good advice from his rep? Or is the rep just towing his company line and trying to keep more of Bob's money in the higher MER fund, thus earning more money for his company?

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    I know your question is primarily about which fund to sell, but since you mentioned "Canadian RRSP", I'll point out that withdrawals will be taxed at your marginal tax rate, and you will waste your lifetime RRSP contribution room; you don't get it back when you withdraw. If you anticipate a large future expense, it might be a better strategy to cease/reduce your $250/mo payroll deductions to the RRSP and instead accumulate some savings outside of the RRSP. An RRSP is not intended to be a short term savings vehicle. The TFSA is a more appropriate account type for such a purpose. – Chris W. Rea Sep 15 '15 at 18:55
  • @ChrisW.Rea but reducing the payroll deductions would cause more tax to be deducted off each paycheque. Currently Bob gets to use that tax money to beef up his investments a little in the time period before taxes are due. I suppose the best thing for short term savings would be if his company supported payroll deductions directly into a TFSA. – Jordan Rieger Sep 15 '15 at 19:23
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    IMHO, there's very little advantage in taking a tax deduction each paycheque that you can't keep when you file your income tax return. Essentially, it's like taking a short-term loan from tax withheld at source, at the cost of future RRSP contribution room. – Chris W. Rea Sep 15 '15 at 22:36
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    1.85% is criminal. Long term, a retiree is advised to take just 4% of a retirement accounts value each year. And one hopes to grow that account 8-10%/yr to keep it growing even after inflation. This nearly 2% fee undermines any possible tax benefits. In the U.S. We have .05% expense ETFs, I'm sure you have the same in Canada. – JoeTaxpayer Sep 16 '15 at 0:22
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    I suggest Bob invest outside the account where he can find sane fees. I wouldn't deposit anything, unless there's a company match. – JoeTaxpayer Sep 16 '15 at 15:03
up vote 5 down vote accepted

It looks like the advice the rep is giving is based primarily on the sunk cost fallacy; advice based on a fallacy is poor advice. Bob has recognised this trap and is explicitly avoiding it.

It is possible that the advice that the rep is trying to give is that Fund #1 is presently undervalued but, if so, that is a good investment irrespective if Bob has lost money there before or even if he has ever had funds in it.

  • This question generated a lot more discussion and debate than I thought it would :-) Much of it centered on whether wikinvest.com/wiki/Active_asset_allocation (what Bob is effectively doing) is actually a good idea. But I think you're right that the account rep's reasoning, at least as he explained it, is a classic sunk cost fallacy. Furthermore, since Bob is still planning ongoing contributions to Fund #1, this withdrawal is just a temporary and small change to his asset allocation during a volatile market, and is therefore quite sensible. – Jordan Rieger Sep 16 '15 at 16:44

The root of the advice Bob is being given is from the premise that the market is temporarily down. If the market is temporarily down, then the stocks in "Fund #1" are on-sale and likely to go up soon (soon is very subjective).

If the market is going to go up soon (again subjective) you are probably better in fictitious Fund #1.

This is the valid logic that is being used by the rep. I don't think this is manipulative based on costs.

It's really up to Bob whether he agrees with that logic or if he disagrees with that logic and to make his own decision based on that.

If this were my account, I would make the decision on where to withdraw based on my target asset allocation. Bob (for good or bad reasons) decided on 2/3 Fund 1 and 1/3 Fund 2. I'd make the withdraw that returns me to my target allocation of 2/3 Fund 1 and 1/3 Fund 2. Depending on performance and contributions, that might be selling Fund 1, selling Fund 2, or selling some of both.

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    If you want to look at it from asset allocation, Bob (for good or bad reasons) decided on 2/3 Fund 1 and 1/3 Fund 2. I'd make the withdraw that returns me to my target allocation of 2/3 Fund 1 and 1/3 Fund 2. Depending on performance, that might be selling Fund 1, selling Fund 2, or selling some of both. – Alex B Sep 15 '15 at 18:20
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    @JordanRieger: The idea of asset allocation is you're not supposed to change it based on market conditions. (Rather, you're supposed to rebalance in response to market conditions in order to maintain the asset allocation you decided on.) – BrenBarn Sep 15 '15 at 19:01
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    @Jordan I would do exactly the opposite. In a bear market, I'd buy more stocks (since everything is cheap), whilst in a bull market, I'd limit my exposure (since bull markets are normally followed by big crashes). – Zenadix Sep 15 '15 at 20:15
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    Jordan, if you can distinguish the end of a market phase, you're doing better than 99.95% of the pros... – keshlam Sep 16 '15 at 3:10
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    @keshlam So it is absolutely impossible to get any sense of the phase of the market and the timeline between bear and bull? Obviously that's not true. There are indications, even if they're not precise -- primarily the opinions of the "pros". So that's why if you're in a bear market you should try to estimate the likely timeline, and try to reduce your exposure to the volatility, at least temporarily. And conversely, in a bull market, you should try to temporarily increase your volatility exposure to reap some gains. Do you disagree with wikinvest.com/wiki/Active_asset_allocation? – Jordan Rieger Sep 16 '15 at 6:27

Bob should treat both positions as incomplete, and explore a viewpoint which does a better job of separating value from volatility.

So we should start by recognizing that what Bob is really doing is trading pieces of paper (say Stocks from Fund #1 or Bonds from Fund #2, to pick historically volatile and non-volatile instruments.*) for pieces of paper (Greenbacks). In the end, this is a trade, and should always be thought of as such. Does Bob value his stocks more than his bonds? Then he should probably draw from Fund #2. If he values his bonds more, he should probably draw from Fund #1.

However, both Bob and his financial adviser demonstrate an assumption: that an instrument, whether stock bond or dollar bill, has some intrinsic value (which may raise over time). The issue is whether its perceived value is a good measure of its actual value or not.

From this perspective, we can see the stock (Fund #1) as having an actual value that grows quickly (6.5% - 1.85% = 4.65%), and the bond (Fund #2) as having an actual value that grows slower (4.5% - 1.15$ = 3.35$). Now the perceived value of the stocks is highly volatile. The Chairman of the Fed sneezes and a high velocity trader drives a stock up or down at a rate that would give you whiplash.

This perspective aligns with the broker's opinion. If the stocks are low, it means their perceived value is artificially low, and selling it would be a mistake because the market is perceiving those pieces of paper as being worth less than they actually are. In this case, Bob wins by keeping the stocks, and selling bonds, because the stocks are perceived as undervalued, and thus are worth keeping until perceptions change.

On the other hand, consider the assumption we carefully slid into the argument without any fanfare: the assumption that the actual value of the stock aligns with its historical value. "Past performance does not predict future results." Its entirely possible that the actual value of the stocks is actually much lower than the historical value, and that it was the perceived value that was artificially higher. It may be continuing to do so... who knows how overvalued the perceived value actually was! In this case, Bob wins by keeping the bonds. In this case, the stocks may have "underperformed" to drive perceptions towards their actual value, and Bob has a great chance to get out from under this market.

The reality is somewhere between them. The actual values are moving, and the perceived values are moving, and the world mixes them up enough to make Scratchers lottery tickets look like a decent investment instrument. So what can we do?

Bob's broker has a smart idea, he's just not fully explaining it because it is unprofessional to do so. Historically speaking, Bobs who lost a bunch of money in the stock market are poor judges of where the stock market is going next (arguably, you should be talking to the Joes who made a bunch of money. They might have more of a clue.). Humans are emotional beings, and we have an emotional instinct to cut ties when things start to go south. The market preys on emotional thinkers, happily giving them what they want in exchange for taking some of their money. Bob's broker is quoting a well recognized phrase that is a polite way of saying "you are being emotional in your judgement, and here is a phrasing to suggest you should temper that judgement."

Of course the broker may also not know what they're doing! (I've seen arguments that they don't!) Plenty of people listened to their brokers all the way to the great crash of 2008. Brokers are human too, they just put their emotions in different places. So now Bob has no clear voice to listen to. Sounds like a trap!

However, there is a solution. Bob should think about more than just simple dollars. Bob should think about the rest of his life, and where he would like the risk to appear. If Bob draws from Fund #1 (liquidating stocks), then Bob has made a choice to realize any losses or gains early... specifically now. He may win, he may lose. However, no matter what, he will have a less volatile portfolio, and thus he can rely on it more in the long run.

If Bob draws from Fund #2 (liquidating bonds) instead, then Bob has made a choice not to realize any losses or gains right away. He may win, he may lose. However, whether he wins or loses will not be clear, perhaps until retirement when he needs to draw on that money, and finds Fund #1 is still under-performing, so he has to work a few more years before retirement. There is a magical assumption that the stock market will always continue rewarding risk takers, but no one has quite been able to prove it!

Once Bob includes his life perspective in the mix, and doesn't look just at the cold hard dollars on the table, Bob can make a more educated decision. Just to throw more options on the table, Bob might rationally choose to do any one of a number of other options which are not extremes, in order to find a happy medium that best fits Bob's life needs:

  • Dollar cost average the funds out of the funds. By drawing them out slowly, you use statistics to decrease the likelihood that you make an undervalued exchange (and, of course, also decreasing the likelihood that you get over on the market by cashing out at a good moment)
  • Draw from both funds. There's no particular reason Bob needs to pick Fund #1 or Fund #2 to draw from. Bob can draw from them in any ratio he pleases. This gives Bob more opportunities to find the balance that fits Bob's life, not just a broker's market opinion.
  • Find money from a third source. Money doesn't grown on trees, but never forget the possibility that you might underestimate your access to resources by focusing simply on 2 funds. There may be a win-win scenario here that Bob didn't even see coming!

* I intentionally chose to label Fund #1 as stocks and Fund #2 as bonds, even though this is a terribly crude assumption, because I feel those words have an emotional attachment associated to them which #1 and #2 simply do not. Given that part of the argument is that emotions play a part, it seemed reasonable to dig into underlying emotional biases as part of my wording. Feel free to replace words as you see fit to remove this bias if desired.

  • I like your attempt here to give the rep the benefit of the doubt. However, there is no basis for saying that Bob made an emotional decision. He is not dumping his stocks just because they are currently underperforming. He is only taking a small fraction (20%) of his stocks out because he needs that money right away, and is using this withdrawal as an opportunity to slightly adjust his asset balance away from stocks during a market environment when stocks are performing poorly. – Jordan Rieger Sep 15 '15 at 23:41
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    You have a good point on the volumes transacted. The argument can still be made that Bob is making an emotional decision. However, the smaller the adjustment, the harder it is to tell the difference between an emotional decision vs. smoothly and rationally transitioning from market to market at opportune moments. It would be interesting to know how emphatic Bob's broker was when making his statement. That would give some qualitative sense as to whether the broker was just probing, or genuinely concerned about Bob's judgement. – Cort Ammon Sep 15 '15 at 23:46
  • Also to your point, it is worth noting that Nightengale betting is consistent with the broker's rule of thumb of only selling when the market is doing well. – Cort Ammon Sep 15 '15 at 23:47
  • Another thing to mention (and maybe I should ammend the question with this) is that Bob was not in the market for the 2008 crash. So he's not "gun-shy" from that perspective. He's just looking at historical volatility in Fund #1, noting that it's heavier in stocks, and noting that the stock market is currently volatile and is expected by most experts to stay that way in the short term. – Jordan Rieger Sep 15 '15 at 23:50

I think that Bob has good reasons for his planned spending and should follow his plan, not the dubious advice from an account rep.

I think the advice Bob is being given is good.

Bob shouldn't sell his investments just because their price has gone down. Selling cheap is almost never a good idea. In fact, he should do the opposite: When his investments become cheaper, he should buy more of them, or at least hold on to them. Always remember this rule: Buy low, sell high.

This might sound illogical at first, why would someone keep an investment that is losing value? Well, the truth is that Bob doesn't lose or gain any money until he sells. If he holds on to his investments, eventually their value will raise again and offset any temporary losses. But if he sells as soon as his investments go down, he makes the temporary losses permanent.

If Bob expects his investments to keep going down in the future, naturally he feels tempted to sell them. But a true investor doesn't try to anticipate what the market will do. Trying to anticipate market fluctuations is speculating, not investing. Quoting Benjamin Graham:

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.

Assuming that the fund in question is well-managed, I would refrain from selling it until it goes up again.

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    This doesn't make sense to me, unless there are additional unstated assumptions. For example, suppose you know that for the next 3 months, Fund #2 is likely to perform better than Fund #1. (Long-term, Fund #1 is better.) Shouldn't you then reallocate toward Fund #2? At least temporarily? Why does it matter what losses or gains happened in the past? All that matters is the likely future performance. – Jordan Rieger Sep 15 '15 at 19:41
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    @Zenadix, so what is considered cheap. If fund 1 has fallen 10% is that considered cheap? So you buy more of fund 1 and soon after if falls another 10%, is this now considered cheap? Maybe buy more of fund 1? What if it falls another 10%? How much money do you have to put into a falling asset before you run out of money and the fund still keeps on falling? This is a stupid idea and one which people loose a lot of money on just at the start of a crash! – user9722 Sep 15 '15 at 21:27
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    @Zenadix, so you are saying that you can find the true value of of a company. Gee, not even expert analysts can do that, as they usually need to make various assumptions. So no valuation is the true valuation, that is why different people value the same company at different prices per share. And even if one could find the true valuation, in a crash the share price may continue going down 50% below the true valuation, and the assumptions used to work out the true valuation would also be revised downwards, especially in an economic downturn. – user9722 Sep 16 '15 at 2:00
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    @GeorgeRenous Estimating the true value of a company is not hard at all if you have the required education. On the other hand, predicting what the market will do in the future... that is nearly impossible, even for the experts. Those who try to anticipate and benefit from market fluctuations are speculators, not an investors. Market fluctuations are often irrational, driven by the emotions of maniac-depressive investors who buy, buy, buy on bull markets and then sell, sell, sell in panic on bear markets. – Zenadix Sep 16 '15 at 15:43
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    @Zenadix, so you base your valuation totally on the P/E ratio. Good luck with that, because that is one of the worst measurement to determine the value of a company, especially in isolation. You may think a company with a P/E of 8 is cheap until in a years time it falls to 4. Yes the share price may have dropped but that may be due to good reason, eg the profits dropping. So is this company a bargin, i would say no. – user9722 Sep 23 '15 at 21:43

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