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One of the most dangerous times to buy stocks is during a rapidly falling market. It is during these times when prices become entirely irrational. You may see a stock that has fallen by 40% or 50% and figure that it is dirt cheap. But then you buy in and see your position quickly cut down as the stock continues to fall. Just because a stock has come down doesn’t mean it can’t fall further. And with individual stocks, sometimes they come down and stay down, never to recover.
Even if you’re buying index funds, you can see markets where they fall a long ways and then continue to fall. The percentage size of the moves will tend to be less (it is nothing for a stock to fall 50%, but fairly rare for an index fund), although big moves down are possible in extreme circumstances. During the crash at the start of the Great Depression, markets fell more than 90% before they bottomed. There was a lot of borrowed money in the markets then, so that kind of move is less likely today, but it does serve as a warning about what could happen.
Market drops are also the best times to buy since falling markets take everything down – good stocks and bad stocks. The bad stocks may go away entirely as they go bankrupt, but the stronger companies will survive and gain market share, meaning that when they come back they’ll be in better shape than ever. Huge gains are made after a downturn ends and heads back up. During a normal year you might see a 5% or 10% gain in a diversified portfolio. Right after a bear market as stocks recover, you can easily see 20% to 30% gains. Indiviudal stocks can easily see 100% or even 1000% gains over the three to five years after a bear ends.
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Catching a falling knife
Buying a stock in a falling market is called “catching a falling knife” for obvious reasons. It is really easy to get cut. The important thing to remember is that stocks tend to fall a lot further than you think they will. Rationality and considerations for stock value go right out the window. This is a good thing since it means you can get a great stock for a great price, but don’t expect to buy a stock at the bottom. You will often buy at what you think is a great price, then see the stock drop another 10 or 20%. Once in a great while you’ll catch a bottom and see it take off the next day and never look back, but that doesn’t hapen often.
Instead of trying to catch a bottom and dump all of your money in, put in money in regular increments. Accept that you cannot know which way the price of the stock will go from day to day and just plan to buy shares on a regular basis as the stock falls. Buy a few shares each week, each month, each paycheck, etc…. You won’t get the best price possible, but you should get a decent cost basis (your average cost per share, equal to the total amount of money you put in divided by the number of shares you own). Just keep in mind that you’re getting lower prices when you buy after a dip than you would have before and that once things start to turn around, you’ll make great gains regardless of what price you pay. Also realize that moves up happen really fast, so if you sit on the sidelines and wait for the bottom, you could miss out on the first 10% to 20% of the market rally.
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Buy even if it goes up
If a stock you’re buying goes up in price after your first buy, you may be tempted to wait for it to fall back down again before buying more. But again, realize that it is impossible to know which way the stock will go. A move upwards may be a false rally, but it may also be the start of a huge real rally. You’ll lose a lot more by missing out on a rally than you will lose by buying shares before the price retreats again for a while. If you buy in equal cash amounts, called “dollar cost averaging,” you’ll be buying more shares when the stock is cheap than when it is expensive, naturally lowering your cost basis.
Likewise, don’t get worried that you’ll be missing out on a huge rally if you see the stock price rise quickly and rush in to buy all you can. There are many false rallies during a market downturn and people who have held onto shares at a loss often sell into these rallies, happy to have gotten a little of their money back, causing the shares to fall back down. It is only after all the shares from these people have been bought out does the real rally begin.
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Avoid chasing things too far
Sometimes we’re just wrong about a company. Sometimes things radically change and a company goes bankrupt. Great companies sometimes just fall apart and never recover, so previous highs become immaterial. Before you start buying in, set a limit to the amount of money you’ll invest. Once you reach that limit, stop and move on to another company for future investments. Even if the stock continues to drop in price and you think you can cut your losses by buying more shares and lowering your cost basis, stop if you’ve already invested up to your limit.
Probably the worst enemy is our pride. You buy your first 100 shares and see the price drop, so you buy more, but the price continues to drop. Then you make a huge buy and double your number of shares because it is “really cheap now” and think you can cut your cost basis a bunch, only to see it fall further. You can end up throwing good money after bad and put a lot more money into the stock than you intended because you’re afraid of needing to sell at a loss and admit you were wrong.
Have you limits before you start and stick to them. If you get all in to a stock and are still down, look at the company fundamentals. As long as the fndamentals show a recovery should come eventually, just sit and wait. Move onto other companies for your future investments. Peridoically check on the fundamentals. If things still look good, hold on and wait. If things change significantly where you wouldn’t buy the stock now, sell out, take the loss, lick your wounds, and move on. Your gains will far outweigh your losses if you stay with it and invest properly.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
