Investors have different risk tolerances, time horizons, and sector preferences. But chances are, you have a particular stock or two that you've owned for a while or plan on owning for a while.
But as large swathes of the market have seen double-digit declines in 2022, what should you do when a company you thought was a keeper dips into the red? Here are strategies you can use when a top stock, or one you were particularly confident in, sees big losses.
Revisit why you bought the company in the first place
The stock market has historically been an excellent engine for wealth creation over time. It's a global market with a large pool of buyers and sellers, which makes prices well known and gives stocks an element of liquidity unmatched by hard assets like real estate. However, this liquidity can make it tempting to buy or sell when volatility is on the rise.
When a stock is crashing, it's vital to remember why you invested in the company in the first place. As Amazon (AMZN 0.37%) stock fell from its split-adjusted price of $188 per share at its peak to a 52-week low just above $100, many investors panicked and ran for the exits during that short period. Amazon Web Services' (AWS) growth was likely to slow after a phenomenal 2020 and 2021, and Amazon was struggling to turn a profit on its domestic e-commerce business as labor and fuel costs chipped away at its bottom line.
However, it's unlikely a long-term investor in Amazon bought the stock simply because they hoped its 2022 results would outperform year over year. A more likely investment thesis would revolve around a bet on the high-margin growth of AWS as the cloud industry continues to grow and becomes an essential part of modern-day enterprise. It could also be a bet on e-commerce and streaming through Prime Video and Twitch.
By revisiting why you bought a stock in the first place, it's far easier to resist the temptation to sell when it falls big on a single earnings announcement. With Amazon stock popping over 10% last Friday in response to a solid second-quarter earnings report, it's easy to say the stock was a buy in hindsight. But in the moment, the situation is far less certain and requires a good deal of discipline and patience to ride out any volatility.
Determine whether the sell-off is valid
Steep sell-offs and sharp rises can seem bewildering to new investors who may question if a company like Amazon is really worth hundreds of billions of dollars less today than it was just a year ago. At times like these, I like to think of a lesson from Morgan Housel's book, The Psychology of Money. The lesson is to know what game you are playing. The stock market is one playing field upon which several different games are being played by several different types of investors. If you're a short-term trader who cares more about a quarterly result than a five-year strategic plan, then a company missing guidance is a big deal. However, the more effective strategy is to find companies that can succeed over the long term and let those companies compound wealth over time.
In this sense, a stock price could deserve to fall, while the drivers behind that sell-off have little to nothing to do with why you own the stock in the first place. For example, Procter & Gamble (PG -0.92%) stock fell by as much as 7% on July 29 due to missed earnings and rising costs. However, the company's cash flows, market position, and product mix make it more than capable of paying and growing its dividend and share buybacks over the long term. P&G is a classic example of a stock that probably deserved to fall, because its quarterly results fell short of expectations. But the decline in its stock price may be largely meaningless to shareholders who chose the stock as a multi-decade passive income stream or to supplement income in retirement.
Think about what could come next and how you would respond to it
Another good strategy to implement if a stock you like falls is to plan what to do next. If it keeps falling, will you buy more? If not, what would it take for you to buy more? If the company's problems persist in the coming quarters, how would that affect the long-term investment thesis? Are the issues that are pressuring the stock likely short-term headwinds or symptoms of a bigger problem?
By asking these questions ahead of time, an investor stands a better chance of making a calculated decision when volatility is high, instead of falling victim to impulsive reactions.
Zoom out and focus on what matters most
Bear markets can be intense and stressful even for the most experienced investors. But investing is all about finding companies that meet your specific objectives, whether that's to grow, produce income, offer a good value, etc. By revisiting the fundamentals, you can give yourself the preparation and confidence needed to make the best decision for your portfolio and your financial health.