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.