Investing is all about enjoying steady business growth that translates into healthy capital gains as share prices rise.
Along the way, it’s also a bonus when you can collect dividends that act as a healthy stream of passive income.
However, share prices do not always go up in a straight line.
Investors need to tolerate significant market volatility as share prices are affected by not just earnings and cash flows, but also the emotions and whims of other investors.
This year has been a tough one for many markets.
The bellwether S&P 500 index has declined by 21.8% year to date while the technology-heavy NASDAQ Composite Index has tumbled 34.6% over the same period.
Hong Kong’s Hang Seng Index hasn’t fared much better, plunging by close to 31% year to date.
Individual stocks have fared even worse, with many hitting new 52-week and all-time lows.
If you are in the unfortunate situation of seeing your stock’s value cut in half or more, how should you react?
Three options to select from
When your stock plunges, there are three actions you can choose to take.
First, you can elect to buy more of the stock.
If the investment thesis was sound in the first place and continues to remain so, then a (much) lower share price presents an even better bargain.
By buying more of the stock at lower prices, you also have the advantage of averaging down to lower the average overall cost of your purchase.
On the flip side, you can also choose to sell the position and cut your losses.
By doing so, you are hoping to prevent yourself from suffering the pain of even greater losses should the share price continue its descent.
Finally, the third option is to do nothing.
Neither buying nor selling may be the wisest choice if you are unsure as to how to react.
Focusing on the business
Now that we’ve established the options you can choose from, let’s drill down further as to how you can make the most informed investment decision.
The key to deciding what to do is to focus your attention on how the business is performing.
The company may be facing significant headwinds and is reporting plummeting sales, profits and cash flows.
As an investor, you need to decide if this drop is temporary or if it points to a more structural problem with the business.
An example may be a temporary fall in subscriber numbers resulting from a price increase.
Over time, customers will adjust to the new pricing and continue to patronise the business if it provides a much sought-after product or service.
In such a case, it makes sense to seize the opportunity to buy more shares if they plunge sharply.
However, if the problem is systemic and involves a permanent, irreversible deterioration in the business’s fundamentals, then it may be wiser to sell the position and allocate the money to a more promising investment candidate.
A tale of two opposites
To illustrate this difference, let’s take a look at several companies that have suffered sharp share price falls in the past year.
Sports apparel and footwear giant Nike (NYSE: NKE) saw its share price fall by 45% in the last year while financial technology company iFAST Corporation Limited’s (SGX: AIY) share price has halved over the same period.
Nike still maintains a strong brand following and its recent woes can be attributed to supply chain snarls, a temporary phenomenon.
As for iFAST, its recent fiscal 2022’s third quarter (3Q2022) earnings saw net profit plunge by 72% year on year.
Despite this weak performance, the group expressed confidence that 2023 should witness accelerated growth as its Hong Kong e-Pension division earnings start to kick in.
Contrast the above examples with home fitness equipment manufacturer Peloton (NASDAQ: PTON) and US used-car retailer Carvana (NYSE: CVNA).
The former’s shares have plummeted 82.5% in the past year while the latter’s share price has lost more than 97% of its value.
Peloton had reported seven consecutive quarters of losses as it faced declining sales and excess inventory as fewer people worked out at home.
In Carvana’s case, used car prices started to plummet while vehicle affordability issues also crimped demand for vehicles. They were previously buoyed by the pandemic because of a shortage of car parts.
With rising interest rates and a slowing economy, it looks like the retailer’s woes are not going away anytime soon.
Get Smart: Hang on in there
It’s never pleasant to see share prices sliced in half.
You need to hang on for better days to come as sentiment may have an outsized effect on share prices in the short term.
However, if you establish that the business is doing fine, it may be the perfect time to buy more of what you own.
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Disclaimer: Royston Yang owns shares of Nike and iFAST Corporation Limited.