What should you do when your favourite stock crashes?

Accusations, clarifications, and counter accusations have flown left, right, and centre. And through it all, the follow on public offer (FPO) of Adani Enterprises has been fully subscribed.

It would seem the storm has passed. But even so, the shock this incident has created will live in the minds of retail investors for a long time.

And with the Union Budget at our doorstep, the volatility in the stock market has jumped massively. This is especially troublesome for traders, but investors too will be cautious.

In fact, even after the budget, we can expect at least some more volatility, even if the Adani group stocks settle down.

This volatility will affect some stocks more than others. There are bound to be a few stocks that will soar due to specific announcements in the budget. And there will be a few that will crash.

What if you are holding a stock that is going down fast? Do you sell or hold or buy more? How actively should you track it?

Well this is a situation faced by investors and traders alike whenever a high conviction stock takes a tumble.

In this editorial, we will examine the different investor reactions to this scenario…and separate the good reactions from the bad.

Do nothing

This is a common approach of retail investors whenever there is a big correction in a stock they hold.

Often there is a stock everyone in the market is convinced about. The fundamentals of the company are strong. It’s one of the fastest growing companies in India. Early investors have made a lot of money and the investors who were late to the party are also making money.

Why wouldn’t everyone buy this stock? Well, often they do. And the stock price takes off.

This is what happened with Tata Elxsi. When the stock price crossed ₹10,000 no one seemed to be interested in selling.

But when the stock started to fall, many retail investors still held on. The stock fell more than 40%.

This approach is akin to giving up. Investors throw up their hands and just hope for the stock to recover.

If it does, they breathe easy. But what if it doesn’t?

Well, then they will eventually have to not only book a loss but also miss out on other opportunities in which they could have put in their reduced capital. This new stock could have done the job of recovering their loss and even made some profit on top.

Clearly, this is a bad approach.

Sell quickly and forget about it

This approach works well, if the company in question is dodgy.

Consider the stock of Vakrangee. It crashed in early 2018. The stock fell about 95%. Many investors lost their shirts.

But those investors who sold quickly, without caring about the profit or loss in the stock, have been vindicated. The stock never recovered.

Thus, if you suspect there is something seriously wrong in a company, maybe something fraudulent, then selling all your shares and not looking back is a good idea.

But what if this is not the case?

Then dumping your shares in panic is a bad idea. You will regret your hasty decision when the stock inevitably bounces back.

A good example is M&M. The stock fell over 60% from early 2018 to the covid low in March 2020. That was a brutal correction. But look at the stock price now.

The polar opposite examples of Vakrangee and M&M should convince you of the need to do your due diligence when it comes to the fundamentals of a company before investing in its stock.

Thus, selling quickly is not always a good approach. It’s only good when the company is shady. But in that case, you shouldn’t have invested in it in the first place.

Buy more

This approach is called averaging. It means you buy more shares of the stock at a price lower than your original buying price.

For example you bought a stock at ₹100, let’s say 100 shares, for a ₹10,000 investment…and the stock falls to ₹80.

You are not worried because you have done your research beforehand and are aware that the fundamentals of the company is intact.

Thus, you conclude that the fall is temporary.

Now if the stock was a good buy at ₹100, it is an even better buy at ₹80. So, in this approach, you buy another 100 shares at ₹80. Now you have 200 shares, at an average price of ₹90.

A better way to average is by investing the same amount of money on both occasions, i.e. at ₹100 and ₹80. You get 100 shares from the first transaction and 125 shares (10,000/80) from the second transaction.

This also gives you an average price of ₹90 but you end up with more shares compared to the first example.

This is how mutual fund SIPs work. Just replace shares with ‘units’ of the mutual fund. You end up with more units when the market falls and fewer units when the market goes up.

As a retail investor picking individual stocks, this can be the best approach when facing falling stock prices…but there is a catch.

Buying more of your favourite stock requires conviction. If you don’t have that then you won’t even think of buying more.

Imagine an investor in M&M over the last 6 years. When the stock fell in 2018, if he chose to do nothing, then he would have felt relieved when the stock recovered sharply after the covid crash.

But if he had conviction in the fundamentals of the business and the efforts of the management, he could have averaged at a price 50-60% lower that his initial buying price.

Imagine buying a great stock at ₹100 with a target of ₹200 and then getting the opportunity to buy it again at ₹50.

When the stock eventually gets to ₹200, your initial investment would have doubled but your follow up investment would have quadrupled.

That’s the power of this approach. All great investors practice this in every market correction. But to do this, you need a high conviction level in your investments.

There is another approach too. Some investors try to become shrewd traders and sell their shares with the aim of buying it back later at a lower price.

If you think you can do this successfully, then by all means go ahead. But remember, this approach requires you to be razor focused on the markets and especially on the stock. It can be the cause of a lot of stress. Do keep that in mind.

In conclusion

Well, these are the various ways in which most retail investors try to handle falling stock prices.

Sophisticated investors use other approaches like hedging, shorting, covered calls, etc. but these are, usually, not practised by retail investors.

What do you think, dear reader. How do you handle falling stock prices? Do you have a specific strategy for such times?

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com