The 2-Minute Thought: When Things Go Wrong

We usually say we sell a stock in three situations.  One is when it does well and becomes clearly overvalued.  Another is when we find something better and cheaper to replace it with.  The third is when things go wrong and it’s clear we’ve made a mistake.  This is usually the hardest situation to judge.  Things can and do go spectacularly wrong sometimes.  But when there is a steep stock price decline accompanied by bad news, have you really made a mistake?  Do you sell or do you buy more?

Things go wrong for many reasons.  The whole market can go bad (2002, 2008-2009).  The entire industry can go bad (retail now, energy not too long ago).  It could be cyclical dip or secular change.  There could be regulatory change.  And then there is company-specific news.  Sometimes, companies don’t do anything wrong, but expectations get too lofty and can’t be met.  Sometimes, they make terrible mistakes.  It becomes clear that they have been running their businesses badly.  They can be caught flat-footed by unexpected competitor announcements.  Or painful turnarounds from past mistakes can take far longer than expected.

All of these situations are difficult.  If you sell, are you overreacting and panicking?  If you hold, are you being stubborn and over-attached?  You want to do neither.

The decision to sell should be based on reasoning no different from the decision to buy.  What is important is to keep the price you paid for the stock out of the decision.  If you are the kind of investor that buys a stock when you see it selling below what you reckon is its fair value, then you should not sell if it remains below fair value -- even if it’s falling ever further below your purchase price.  You may buy more.  But that’s easier said than done. 

In retrospect, it’s always easy to see what you should have seen before – too much debt, bad acquisitions, unfavorable fixed price contracts, over-investment in unneeded capacity, expansion into the wrong markets.  But in retrospect, now that you see it, it should go into the same kind of analysis you did when you bought.  When there still is so much you do not know, only using the same criteria and discipline you used when you bought can help you to think about whether to sell.

And while there is no singular formula for dealing with a declining stock, there is much to be said for being a little patient. 

Jason Zweig of The Wall Street Journal wrote in a 2016 column that there were 44 U.S. stocks that had generated cumulative total returns of 10,000% over the last 30 years.  He called them “superstocks,” and they had one thing in common: They all had had a “near-death experience” where they lost 70%, 80%, or even more of their value.  Their underperformance was “staggering” and surely, it was fear-inducing.  But if you had been able to hold on, you would have seen things evolve in a way you couldn’t have imagined. 

Of course, this is not to say that all or most stocks in steep decline will come back.  Some surely will go to zero, and others will find a new home trading at much lower levels for a long time.  But being slow to act when you know there is much you don’t know – whether you are buying or selling – can be a good thing.  Sometimes, we cannot imagine how much things can change for better or worse in the future. 

How To Deal With The Ups and Downs...

Anne is writing about long term returns on page 4. I will deal with the shorter term here. It seems like every week there is a problem of overwhelming magnitude on Wall Street. If we don’t act on it, surely something dire is going to happen.  

But you know these overwhelming problems often are not that overwhelming. Now keep in mind I am not saying you should pay no attention to Hurricane warnings but the reality is, we often overreact to the short term noise of the day. Take a look at the chart at the bottom.

The failure of the budget fix in the U.S. back in 2013 was pretty big news and pretty scary but it didn’t have much lasting affect on the market or the economy. The same goes for the near collapse of Greece in 2015 and so far, the Brexit vote.

The moral of this story is it is important to keep your head when everyone around you is losing theirs, or as the saying goes, “exercise extreme sloth.”  Disregard the volatility and the crisis du jour, sit tight and focus on the longer term picture (see chart to below).  But this is hard to do. Morningstar the mutual fund tracking service examined 1,930 mutual funds over 15 years through June of this year. It found that the mutual funds earned one percent more per year than the investors in the funds. How can this be? It’s because investors got spooked at the wrong time and sold out and then, with equally bad timing, got excited again and bought back in.  A one percent return over 20 years on a $500,000 portfolio is $110,000. We’re talking real money here.

Jason Zweig the columnist in the Wall Street Journal, has joked that his job in personal finance is “to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself”. There are not that many Real Truths in investing. The ones that are out there are all pretty simple. Here are four from John Authers a columnist in the Financial Times (September 3-4, 2016).

1.  Always worry about costs.  We don’t know that much about the future but we do know what we are paying for investment advice. Pinch your pennies here.

2.  Be humble.  The truly smart people know how little they actually know about the future.  Rein in your overconfidence.

3.  Rebalance.  If stocks are zooming higher and bonds are dawdling, go against the grain and peel back your winners and add some to the losers. It is no exact science but ‘reversion to the mean’ does still live on Wall Street.   

4.  And finally, remember it is all about risk and return.  Hindsight is 20/20. We know exactly when we should have loaded up on risk and when we should have cut back. But this is all rear view mirror stuff. Looking ahead is very different. Try to imagine what it would feel like to lose 10%, 20% or even 40% and what this would do to your life plans. Then with this in the back of your mind, invest accordingly. You are less likely to wake up anxious in the middle of the night thinking, oops I didn’t sell down to the sleeping point.

Finally, a Financial Dictionary That's Fun To Read

Quick, what is the definition of “stock market?”  According to Jason Zweig’s new book, The Devil’s Financial Dictionary, it is:

               “A chaotic hive of millions of people who overpay for hope and underpay for value.” 

Jason Zweig is investing and personal finance columnist at The Wall Street Journal.  His lexicon, inspired by American satirist Ambrose Bierce’s The Devil’s Dictionary, fairly well skewers the full range of our human foolishness and pretensions as we invest. 

The book won’t be released until mid-October, but here’s a preview of some choice entries:     

BULL MARKET, n.  A period of rising prices that leads many investors to believe that their IQ has risen at least as much as the market value of their portfolios.  After the inevitable fall in prices, they will learn that both increases were temporary.  See BEAR MARKET.

BEAR MARKET, n.  A phase of falling prices when you can no longer bear to think about what a fool you were for not selling your investments – which is generally a sign that you should think instead about buying more . . .

HIGH-NET-WORTH INVESTOR, n.  A very big target.

INDIVIDUAL INVESTOR, n.  Someone who, without wise advice, is likely to ruin a small portfolio, generally $1 million or less.  See INSTITUTIONAL INVESTOR.

INSTITUTIONAL INVESTOR, n. Someone who, without wise advice is likely to ruin a large portfolio, generally $10 million or more.  See INDIVIDUAL INVESTOR.

IRRATIONAL, adj.  A word you use to describe any investor other than yourself.

CONTRARIAN, n.  A sheep masquerading as a lone wolf.

DAY-TRADER, n. See IDIOT.

IDIOT, n., See DAY-TRADER.

OUTLOOK, n.  A guess.

ALPHA, n.   Luck.