Every experienced investor has had it happen: You look at a promising stock for a long time, you think you've learned everything you need to know about the company and its business prospects, and you finally decide to buy. Then, in what seems like a blink of an eye, some unexpected news item comes out, and the stock price falls significantly.
What should you do next? Should you dump the stock immediately and cut your losses? Should you hold on and hope this is a temporary setback? Or should you stick to your guns and take advantage of low prices to buy even more shares?
Experiences like this are enough to make any investor lose confidence. You start to second-guess whether your analysis was sufficient, whether you missed any obvious signs of trouble, and whether you let your emotions get the better of you. For some investors, it's enough to make them give up on individual stocks and retreat to the relative stability of mutual funds. After all, in a diversified stock fund with hundreds of companies among its holdings, even a big drop in one stock isn't enough to put a major dent in the overall portfolio.
After you get over the immediate shock of a big loss, however, you can start thinking rationally about your investment again. You realize that unexpected events happen to every company from time to time, and the resulting price declines often end up being short-term phenomena that look, in hindsight, like the perfect buying opportunity. Yet there are also cases of companies whose initial drop turned out to be the last chance to sell before a final, fatal collapse. For instance, during 2000 and 2001, Enron shareholders had numerous opportunities to sell before the final drop in November 2001 took most of the last $5 of share value away from a stock that had once traded near $100. How can you tell which situation your stock faces?
When calamity strikes, the most important thing to do is to look at the reasons that led you to buy the stock. You can then evaluate the bad news in the context of your rationale for buying the stock and determine whether anything fundamental in your assessment of the company has changed. If the news item is unrelated to the reasons why you purchased the stock, then you may prefer to ignore the bad news and hold your shares. On the other hand, if the news item strikes at the core of why you wanted to own shares, and your primary justification for buying those shares is no longer present, then you should strongly consider selling,
For example, consider the recent drop in shares of Caterpillar
If you bought Caterpillar solely as a short-term trade on hopes of better-than-expected earnings or some other positive news, then a bad earnings report followed by a big move downward in stock price is just about the exact opposite of what you wanted to happen. Since the bad news puts an end to your reasoning behind your stock purchase, it no longer makes sense for you to hold it. Continuing to hold the stock would just be an emotional attempt to recoup your losses and a denial of your initial thinking.
On the other hand, if you bought Caterpillar because you saw it as a solid company with good management and strong long-term growth prospects, then you might conclude from the news report that nothing has changed. Although short-term factors may have lined up against the company and its stock, nothing in the news indicates any departure from a successful long-term business strategy. Indeed, the lower stock price may make the company even more attractive and tempt you to buy additional shares.
Keep your perspective
Regardless of what decision you make, you should be sure that it's consistent with your reasoning and investment strategy. If you decide to sell the stock, make that decision and don't look back. Often, stock prices will rebound from big drops, but don't let that cloud your judgment or persuade you that you should buy back in at higher prices. If, on the other hand, you decide that the stock is still attractive and you therefore want to buy more at lower prices, bear in mind that you probably don't want to concentrate too much of your assets in one company's stock, no matter how good of a prospect it is.
If you find it difficult to get over the shock of a big loss, look at the bigger picture. If you have a diversified portfolio that includes many companies, a loss in one stock may not have as big an impact on your overall net worth as you may think. Even a major decline of 50% or more in a single stock may only cost you a few percentage points when you consider the total value of your investments.
Dealing with investments that don't behave the way you want them to is one of the most difficult challenges that investors face. If you decide to invest in individual stocks, however, it will eventually happen to you. By attacking the problem rationally and knowing the reason why you bought your stock in the first place, you will know your best course of action.
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Fool contributor Dan Caplinger often goes double or nothing when he loses informal bets, but he starts getting nervous when he loses 16 or 32 times his original bet. He doesn't own shares of Caterpillar and was fortunate enough to avoid Enron in its time. The Fool's disclosure policy is sometimes double but never nothing.