In an ideal world you'd never have to worry about making bad investments. In reality, though, some stock picks go badly wrong for even the best investors. If you buy individual stocks, you'll inevitably have to deal with a big one-day drop after a negative earnings announcement or some other piece of bad news. How you respond in the face of maximum stress will dramatically impact your long-term results. To help you figure out what to do when one of your stocks tanks, here are three things you should include in your action plan.
1. Avoid panic.
The biggest mistake many investors make is to fall prey to emotionally driven decision making. A big stock-price drop almost always produces strong emotions, whether fear of further losses or excitement at the chance to buy a much-loved stock cheaply. Regardless of which way your emotions head, it's important to control them before you push the buy or sell button.
2. Get the full story and see if it fits with your vision of the company's future.
A stock can plunge for any number of reasons. Sometimes, it's a knee-jerk reaction to a bad financial report, and investors are overly quick to extrapolate bad news far into the future even if the main cause was short term in nature. Even the hint of impropriety is enough to strike fear into many investors, particularly if things like accounting irregularities or fraud come into play.
Before you react to a piece of bad news, you need to understand it, and you also must figure out how or whether it affects your reasoning for buying the stock in the first place. An event that is a good reason to sell for one investor might not be for another. For instance, if you own Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) primarily because you think Warren Buffett has a competitive edge that even his successors at the company won't match, then his eventual departure from the conglomerate's leadership will be a reasonable cause to sell shares. If, however, you think the array of businesses Buffett has put together will be successful for decades to come, then any drop due to his future departure could simply be another buying opportunity.
3. Don't jump to extremes.
Many investors forget that even if they decide they're not as excited about a stock as they once were, they don't necessarily have to sell their entire position in one fell swoop. If you're concerned about a stock's future but think it might pull through, then selling a portion of your holdings to reduce risk while still leaving exposure to potential profits can be the best compromise.
Similarly, if you're convinced that a stock-price drop is a bargain opportunity, you still shouldn't feel compelled to put all your spare cash into that pick right away. Often, share prices will keep falling, giving you a chance to pick up even bigger bargains if you save a portion of your investing capital until later. It's important to weigh your risk tolerance against moves you make to take advantage of disruptive events that hit a stock price hard.
As an investor, you'll eventually have to deal with a plunging stock. If you keep these three things in mind, you'll have a better chance of making the most of the opportunities they present while minimizing the damage you take.
Dan Caplinger owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.