Investors were reminded of how volatile markets can be in early August as stocks sold off following a slew of weak economic data that fueled concerns about a possible recession. Previous market darlings such as Nvidia and other beneficiaries of the boom in artificial intelligence spending saw their stocks fall by 20 percent or more over a span of days. This level of volatility can cause fear and may even lead to more selling as investors look to get out of the market before things get any worse.
So what should investors do when stock gains evaporate or profits become losses? Here’s how to decide what to do when a stock you own plummets.
Seeing a stock decline by a significant amount is likely to cause an emotional reaction in most investors. It’s natural to feel this way. After all, you’re losing money, which can create feelings of fear and loss.
But we don’t make our best decisions when we’re experiencing an emotional event, so it’s best to try to manage your emotional response to a large stock decline. It might help to take a deep breath or slowly count to ten. Anything that helps slow down your emotional response can help you make a better decision.
Even though you have all these feelings about the stock – you might be mad at the CEO for whatever caused the stock to decline or want to scream at whoever told you to buy the stock in the first place – the stock has no feelings about you. It doesn’t know or care where you bought it or what you do with it in the future. Understanding these feelings can help you control them better and make a more rational decision.
When a stock is declining and it’s being talked about in the financial media, it’s easy to get distracted. Try to remember the basics when you’re in the midst of a chaotic decline. A stock represents an ownership interest in an actual business and isn’t just a price flashing red or green on a screen.
The long-term success of the stock will depend on the future results of the business. Many market commentators will have thoughts about where the stock is headed next and whether or not it will recover losses. Many of these people have more of a trading mentality and don’t actually follow or understand the underlying business. It’s probably best to ignore comments that aren’t directly related to the business itself.
Once you’ve got your emotions under control, you’ll want to quickly determine the cause of the stock price decline. Stocks can move for a number of reasons, but a large decline relative to the rest of the market is most likely to be caused by a company-specific event such as a disappointing earnings release or an unexpected change in management.
As you analyze what’s causing the sell-off, think about how the event does or doesn’t change your view of the business. Why did you buy the stock in the first place and how does the new information impact that reasoning? You might decide that a disappointing earnings report is due to a short-term issue that was outside of management’s control, or you might think it’s a sign of new competition challenging the company’s market position.
During major declines, there can sometimes be rumors that can add further discomfort. Try not to get distracted by these rumors and instead focus on the known information that’s available. If you think every rumor is valid, it increases your chances of making a poor decision.
If you’re a long-term investor, you’ll want to constantly be evaluating the long-term outlook of the company you own. Typically, the majority of a company’s value comes from the earnings it will generate beyond the next five years, so the long term matters a lot.
As you’re grappling with a large stock price decline, it’s important to ask whether the long-term outlook has changed and if so, how? It’s fairly normal for a company to miss Wall Street’s earnings estimates occasionally or issue guidance that is below what analysts were expecting.
But you’ll need to understand the “why” behind these market disappointments. Maybe competition is heating up or a new product isn’t performing well with consumers, both of which are reasons why the long-term outlook could be impacted.
Ultimately, you’ll need to make a decision about whether to buy more of a stock suffering a big decline, sell it (either a portion or entirely), or continue to hold it in the same quantity as before. The decision will come down to the valuation of the stock after the decline and the other investment opportunities available to you. Here’s how to think about each option.
Buy – If you determine that the cause of the decline is short-term in nature or that the market has misinterpreted the new information, you could have a buying opportunity on your hands. If you thought the stock was attractive before and new information doesn’t change your long-term outlook, a lower price represents an even better investment value.
Sell – Selling a stock after a major decline can be difficult to do, especially if you’re realizing a loss, but it may be a wise decision if new information has caused you to change your opinion of the business’s future. Holding on until the price recovers when your outlook has worsened is wishful thinking, and you’re typically better off just exiting the position. If the broader market has also declined, you could have better opportunities to add new stocks to your portfolio rather than holding a potentially underperforming stock.
Hold – Doing nothing, or holding the stock, may be your best option if you need to do additional research before making a decision or if the position is already a sizable part of your portfolio. Even if you think the stock is attractive, you may decide that it already accounts for as much of your portfolio as you’d like.
If you do decide to sell, you may be able to use a strategy known as tax-loss harvesting to offset other investment gains or reduce your taxable income. Losses beyond the allowable deduction can also be carried forward into future tax years.
No one likes watching a stock they own decline, let alone plummet. But if you are able to stay calm and manage your emotions well, you should be able to make a good decision. Focus on the underlying business and the reason for the stock’s decline, always keeping an eye on the long-term outlook. By thinking through these issues you should be able to arrive at a buy, sell or hold decision in a timely manner.
If you’re just starting out, consider getting started with low-cost index funds before picking individual stocks. Index funds that track broad market indices such as the S&P 500 are less volatile than individual stocks, thanks to the benefits of diversification. A lower volatility strategy may make it easier for investors to stay invested for the long term.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
