Profiting From Falling Stock Prices
When buying stocks, falling market prices are your friend
Falling stock prices cause panic in some investors, but fluctuations in the market represent business as usual. Investors who are comfortable with this reality know how to hold their investments and how to recognize investments that are good purchases when stock prices are dropping.
Some keys to making a profit from an economic downturn are to ignore your panic mode, purchase stocks at reduced prices, or build a diversified portfolio which should include U.S. Treasuries, bonds, U.S. stocks, and foreign stocks (or funds).
Falling Stock Prices and Instincts
Human nature is to follow the crowd, and investors in the stock market are no different. If prices are going up, the kneejerk reaction might be to hurry up and buy before prices get too high. However, this often means that you're rushing to buy a share of stock for $50 today that you could have purchased for $45 yesterday. When thinking about it that way, the purchase seems less attractive.
The opposite is also true. If prices are falling, people often rush to get out before prices fall too far. Again, this might mean that you're selling a stock for $45 that was valued at $50 yesterday. Reacting in this manner does not help an investor make money.
Controlling your "flight" instincts will keep your long-term growth strategy intact.
While specific events or circumstances can cause stocks to spike or plummet and force investors to take quick action, the more common reality is that day-to-day fluctuations—even the ones that seem extreme—are just part of longer trends.
If you're in the market primarily to build your nest egg (long-term growth), most often the best course of action is to do nothing and let the long-term growth take place. It is possible to make a profit from falling stock prices if you are quick, and purchase a stock for less than the price you can sell it for—but this can be tricky, and is more in line with the unreliable method of market timing (which is more similar to day-trading than investing).
Falling Stock Price Strategy
As you witness a sell-off of stocks because prices are dropping, you could take advantage of this situation by knowing in advance which companies you are going to invest in should prices begin to fall.
When You Should Buy Stocks
The time to look for investments to buy is not when stock prices drop—you should find these when the market is performing well. Look to identify companies that have weathered economic crises before, and purchase those stocks after prices have fallen.
Purchasing stocks when prices are lower generally leads to profits when the prices rise again, as they always do. The market, economy, and stock prices all follow a cycle. In general, the market has been in a continuous climb for quite some time.
Over time, the market rebounds and prices rise again after falling. This has happened over and over, generally with an increase above previous prices.
The Standard & Poor's 500 (S&P 500) index has climbed since its inception—when you look at a performance chart you can see the companies that make up the index have performed throughout many price avalanches.
Other indexes you can look into are the Dow Jones Industrial Average, the Nasdaq, and the New York Stock Exchange (NYSE)—to name a few.
If Your Stock Prices Drop
What if the price of one of your stocks falls from $60 to $40? Although you are sitting on a substantial loss of more than 33% of the value of your holdings, you’ll be better off holding it in the long run for two reasons:
1) If you reinvest your dividends to buy more stock, you increase your ownership in the company. Also, the dividends will purchase more shares at a reduced price. In other words, the further the stock price falls, the more ownership you can acquire through reinvested dividends.
2) If you have additional investment funds available, you might do well to buy more stock at lower prices. If you truly are focused on the long-term outlook, the short-term losses of stock price drops are less significant.
Build a Portfolio for Falling Stock Prices
It has long been passed around the investing community that diversity helps to mitigate risks. Your portfolio should be built from a wide array of investment types. Stocks, mutual funds, index funds, bonds, and Treasuries all perform differently under different economic circumstances.
For example, Fidelity has built a few portfolio models that you can use as a guide for your portfolio. A balanced portfolio should have approximately 40% bonds, 35% U.S. stocks, 15% foreign stocks, and 10% short-term investments.
Every investor's situation is different and each investor's portfolio should reflect their tolerance for risk, financial abilities, and investing goals.
Your bond category should be made up of companies that have performed well over long periods of time, and U.S. Treasuries. The same criteria for choosing bonds from performing companies should be used to choose stocks—a good indication is a long run on the S&P 500 or another stock index.
Foreign Stocks and Short-Term Investments
Since many investors are hesitant to venture into foreign markets, there are plenty of foreign stock index funds from well-known financial companies such as Vanguard, who offers FTSE All-World ex-US Index Fund ETF Shares (VEU). Conduct some research and find some that you like for your portfolio.
Your short-term investments can take the form of certificates of deposit, short-term bonds, or money market accounts. Diversifying your portfolio in this manner mitigates risk by using all of the categories of investments to work against the poor performance of one or more of the other categories.
A Few Persistent Risks
While most long-term stockholders don't need to fear sudden dips, there are a few risks that can cause serious issues.
It’s possible that if the company becomes undervalued, a buyer might make a bid for the company and attempt to take it over, sometimes at a price lower than your original purchase price per share. This is known as a hostile takeover, where the majority of shares are purchased and a person or party becomes the majority owner. This has a number of implications for investors, as sudden changes in management can affect market performance.
There are always risks when investing. Use diversification and monitor the companies you have invested in to ensure you mitigate the amount of risk you take on.
You might not have liquidity through your investments during a decline in stock prices. If you don't have the cash to cover immediate expenses, you might have to sell shares at a significant loss. A good rule of thumb for avoiding this is to invest no more than 10% of your income or assets at any one time.
People tend to overestimate their skills and ability to estimate investment opportunities. The company you picked to invest in, or that was recommended to you, might not be as good a performer as you thought. Accounting skills, industry knowledge, and insights from friends—while great to have—are no match for investor sentiments, fear of loss, and panic.
As you navigate the roller coaster ride of investing, remember that a strategy (and sticking to it), a thorough analysis of prospective investments, and patience will help you make a profit from falling stock prices, and from the market in the long run.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.