2018 has been a year full of scary headlines and big drops down in the stock market. If you’ve been an investor during this time, I’m sure you’ve seen multiple days where your stock drops in value much more than you would’ve liked.
Of course the invention of the internet has proliferated the potential for overreaction on every day of big stock drops.
Twitter can be especially bad. A 1% drop in stock prices can set the Twitterverse ablaze, with people and articles popping out of the woodwork to give their bad opinions. But if you follow the right people, you can get good perspective that helps you think in a more profitable mindset.
For example, instead of over dramatizing the 1% drop and creating worry and dread like the media, the Twitter accounts I follow were sarcastic, funny, and making comments like @michaelbatnick:
“S&P 500 tumbles at the open to +5.9% for January.”
Wow.. good point… the market has been crushing it since 2009. Compare that what happens when you Google “S&P 500”:
“What’s behind the stock market’s biggest one day drop since August”
With a picture of a guy in a suit (looks like he works on the trading floor) with his balding head buried into his hand in tired frustration.
Glass half full vs. not, right?
Anyways, let’s talk about the big picture instead of little picture. When a stock you own sees a price drop, it can be very good or very bad. But you have to be thinking long term.
The difference is in the impact of long term business results.
When a stock drops, a lot of the time it’s because something happened that was less favorable. Like with Apple earlier in the year, iPhone X demand dropped (according to headlines) “because of lower demand because of the $1,000 price point”.
It’s not necessarily bad for the long term. If it’s a temporary hiccup, but Apple continues steady growth, then that looks like a chance to bargain buy.
But say people are straying away from Apple because Androids are now the “cool” phone. In that case the demand is a symptom of lower revenues and earnings to come. That’s where it’s bad.
You can never tell with certainty which of the two cases it’d be for every (or any) company. It may get harder with industrial stocks or b2b businesses.
That’s why we need to differentiate from a numbers standpoint. It’s the only way to be able to analyze any big stock drops– which is how to increase chances that we’ll be more right than wrong.
I’ll give you a couple more examples.
Let’s say earnings growth went from 12% a year ago to 5% this year. But net cash was consistent as was book value and revenue growth. I’d call that a hiccup. They could’ve had a random large expense suppressing earnings (like a tax liability or expensive lawsuit).
But let’s say a stock went from 12% earnings growth to 5% growth AND lost 10% of book value. Well, that shows a longer term problem. They now have less assets than the year before– which lowers future profitability.
That’s the kind of stuff to look for. And every situation will be different, so every determination will need to be an intuitive one.
The more you analyze stocks and the more you plug in numbers into a spreadsheet, the better you’ll get at making determinations like this.
Making the Right Investing Mindset Automatic
Try Googling a simple stock market phrase like “S&P 500”. Chances are, you’ll see two contradicting headlines, such as:
“S&P 500 closes lower in biggest reversal since February 2016 as rates pop”
“Don’t Panic. The S&P 500 Will Turn Recent Weakness Into A 15% Gain”
Which is it? As a beginner this can be daunting– and you just HAVE to know the real answer.
Well compare it to when you first started driving. Routine things like merging onto fast freeway traffic was terrifying. Every move of the steering wheel, every placement of your hands, all laboriously thought out and fretted over.
My first attempt at the driving license test was a laugh. We pull out of the DMV parking lot and I hang a right to the first light. It’s red and we are going right. So I stop. There’s cars coming, but I still have a bit of space.
Here’s the thing. I knew to be a good driver you had to be assertive and have quick reactions. Perhaps I overestimated just how much was needed.
I make a snap decision and gun it, essentially cutting off the traffic going straight. It wasn’t terrible, no cars honked, but it was very aggressive and I really put my foot on the pedal. The tires squealed. My driving instructor, after collecting himself, tells me to pull the next right back into the DMV parking lot. Fastest test ever.
Looking back, it’s funny to see how my inexperience caused me to make a big mistake and fail my test. I didn’t feel calm during it. I was overthinking it big time.
Now I drive as second nature– as I’m sure all of you do too. But that overwhelming of the senses, all of the things you need to think about at once (especially if learning to drive stick), it all takes up so much mental effort when you don’t have experience.
It’s the same with the markets.
And the media wants to feed off of that panic, that worry, to keep you addicted to their emotional (and not helpful) headlines and narratives. They’ll never actually teach you how to succeed in the stock market, because they know you’ll realize how silly their articles are.
Whereas when you have the knowledge and experience to understand that the market sometimes goes down… and that’s okay… you have a calm that keeps you from making stupid mistakes like selling too soon.
I received an email from eLetter subscriber and VTI client Joshua, who had some great perspective during a time of big stock drops:
“PS. i bet you been getting a lot of email about what to with the big correction/ crash today.. Its weird, but i feel as cool as a cucumber, while everyone else freaks out around me.”
That’s exactly right, cool as a cucumber. Instead of feeling sad about a smaller brokerage account balance, I’m indifferent. I know it’s going to change again tomorrow. And I know that what happens in one day isn’t going to make any difference especially because I’m holding for the long term anyways.
What About Stock Drops and Technical Analysis?
With movements in the market, you’ll undoubtedly start to hear terms like “momentum” and “moving day averages” after big stock drops or price rises.
Reader Jose asked a question about trying to time this momentum and create a strategy based on what happens with the price movements:
I have just begun my learning process in the stock market, and I just read your beginner’s ebook. Dollar cost averaging definitely makes a lot of intuitive sense to me. I noticed that you mentioned to not sell stocks that you haven’t held for over a year, but I have heard some people talk about selling when your share prices have dropped 10%.
My question to you is, why not sell when that happens? Say you bought 10 $10 shares, and the price drops to $9. If the price drops to $5 and then you see it start to rise again (say to $6), you can take the $90 that you got when you sold the 10 shares, and then use it to buy 15 $6 shares. Doesn’t that ultimately save you money?
In theory, a stock going up will keep rising and a stock falling will keep falling, for a while. The idea is to buy or sell when you see a reversal of the trend (like a low of $5 now trading at $6), and ride them.
So in your question, yes selling at $9 and then buying at $6 saves you more money than holding down to $6.
The problem (big problem)…
Is that the momentum stuff doesn’t work consistently enough to be reliably used. It’s been proven that a stock’s movement today has NO correlation from what happened yesterday (see: A Random Walk Down Wall Street for the source).
It’s also much harder to pick a “top” or peak than you’d think (I show this nicely with charts in the Value Trap Indicator book).
And think about this, if momentum was really the superior strategy, why are all the top billionaire investors value investors and not momentum investors? (Soros is an exception, but is a macro trader, not momentum).
Now I’m seeing studies come out about the power of mixing momentum and value investing.
But what’s really going on there is what you see in how stock prices react to FEAR and GREED. Buying a stock that continues to rise and keep a “trend” is not rising because of the trend, it’s rising BECAUSE it’s either thriving business-wise or has investors excited and greedy, or both.
The algo-computer traders then magnify this effect.
They’re not causing it. Momentum isn’t causing it. Momentum (that continues) is a consequence of these type of things.
Which is why we can’t rely on it.
Jose, your example would work great if momentum was a reliable measure for creating profits. But it’s generally not. That stock could just as likely shoot up to $11 after hitting $9 as it could drop down to $7. The market can be very random.
Taking Action (or Lack of) for Better Results
The key to finding success despite what happens with the stock price is to continue to hold for the long term, and trust that the businesses behind the stocks you own will do all of the work for you and compound your capital in that way.
You see, you don’t actually lose money when a stock drops… UNLESS you sell.
It’s really just a paper loss, and it has no reflection on the actual health of the business if the market is being irrational at that time. What you have in the stock market is a huge swath of players trying to determine a stock’s value constantly, all with different financial situations, goals, and motivations.
Add the obsession of short term price movements and day traders trying to capitalize on that from second-to-second, and you have a wildly chaotic marketplace instead of collection of rational buyers and sellers.
You have mutual funds that are frequently more concerned with attracting clients (by owning the stocks that are popular) rather than actually attaining great long term performance. You have a huge influx of index investors who simply buy the S&P 500, which creates a self-reinforcing loop of the big stocks getting bigger.
You have many investors and funds so focused on short term results and next quarter’s earnings release rather than what the performance of this stock will be after holding it for 10 years.
I could go on and on, but the bottom line is that there will be pockets of time where a stock could be much more expensive or much more cheap than its business is really worth.
It’s up to the individual investor like yourself to determine these cases and make your buying decisions off that.
When it comes to selling decisions, the mindset needs to be similar. Instead of focusing on the fact that you have a day of many stock drops throughout your portfolio, focus on what’s happening inside of the business through the financial statements (link for how to read an annual report).
Understand the difference between real business problems and stock market hype, and your portfolio will thank you.
There’s no reliable data that definitively says how to predict what any particular stock will do in the short term. There is plenty of data that shows that the stock market tends to go up by about 10% a year, and has done so for many decades.
Combine that data with this understanding: if a business you own continues to do well, chances are it can achieve 10% annual returns per year or greater. But to get those types of returns for your portfolio, you have to hold your stocks through that adversity.
So shut off the constant feed of market reporting and chaos, and plug yourself in with valuable education on learning how to analyze great businesses. It’s likely to be a much more profitable endeavor.