In the past few weeks, I watched one of my stocks drop significantly without any apparent news. As you can imagine, there was a lot of discussion on the boards about why it dropped, and many Fools planned to use the dip as a buying opportunity. When a stock drops suddenly, though, I do not believe that it's a good idea to automatically rush to buy more, even if you are buying regularly in a Drip. If you're doing regular purchases every month, I believe that you should continue making the purchases as scheduled -- and that's it.
Let me make my case, and see if you agree with me.
The first question that comes up is "why does a stock drop in price?" Often it has nothing to do with its underlying value. For example, if a stock is running up fast, traders may notice the stock and start to buy it. At some point, the stock gets so high in price that people start to sell. Once the price stops rising in the near-term, some people stop buying, more start selling, and the price drops. Sometimes the price drops quite fast, and a panic can start. When this happens, the stock price may drop below what the stock is worth. At that point it becomes attractive to people to buy, and the price will stabilize and hopefully go back up, but it doesn't always.
All of this can happen without any real news. Let me address another reason why a stock drops, beyond just the psychology of investors.
Sometimes it drops because bad news will be coming out soon. Many times you can see a stock drop fast for no apparent reason. Then, maybe two or three days later, the company announces that it won't make the next quarter's earnings, or that sales have dropped due to competition, or it has trouble collecting on receivables. How did this "secret" news get out beforehand?
Think about where you work. Does everything stay secret? If a round of layoffs ever comes, don't you usually hear rumors about it in advance? If someone got a big raise, doesn't the rumor go out? The same holds true for most things -- if two people know something, it's not a secret. Conversations can be overheard at lunch, people can accidentally spill news to friends, spouses inadvertently leak news to other spouses. There are many ways that secrets are leaked, unfortunately.
So, if you see your favorite stock dropping like a rock, and you rush out and buy more, you may find you've bought into bad news. It would be sad to buy a load of stock just before some really bad "official" news breaks. The result for you would be jumping in for even greater losses, and maybe feeling a little on the stupid side. Have I ever done such a thing? I don't think we're talking about that right now.
Finally, often a stock drops after bad news is truly released and you'll want to buy more, because it's basically still the same good company, right? Plus, all of us love a bargain. If you could buy a stock at a low price because other investors have panicked, wouldn't that be nice? As the stock went back up to a reasonable value, you'd get a nice return.
Here's where I love dollar cost averaging in Drips. As your stock is rising higher, you are buying fewer shares with the same dollar amount. As it drops, you buy more shares. However, when you make your regularly scheduled purchases, let's say $100 a month, you aren't sinking a lot of money into a stock that may be headed even further south -- the way even a leader like Intel (Nasdaq: INTC) might. (We don't know! However, we sent $100 to Intel last night after Tuesday's column was published. That'll either be invested on October 2 or in early November, depending on when they receive the check. No big deal either way.)�
Finally, dollar cost averaging also allows you to make your purchases at an average price that is going to be closer to the stock's bottom than its top. So, when bad news is released, you should continue to Drip into the stock if you understand the news and its ramifications, as you'll lower your average cost even more.
In summary, I believe that if your Drip stock drops suddenly, it is not a good idea to put a lot of extra money into it right away. The best course is to continue your program of regularly scheduled purchases. To discuss this and your thoughts on the subject, visit us on the Drip Basics board.
