Some of you may remember the flash crash of 2010, when the prices of certain stocks fell precipitously in a matter of minutes. To refresh your memory, check out the experience of Mike McCarthy:
Meet Mike McCarthy, the man who got flash crashed.
In a tragic twist of fate, McCarthy's broker happened to hit the button on a market order to sell his 738 shares of Procter & Gamble (NYSE:PG) at roughly 2:46 p.m. on May 6, 2010. That order was filled at $39.37, not only the lowest price in roughly seven years, but also a dramatic difference from the $60-to-$63 [range] P&G had traded at only moments before and after McCarthy's trade.
I feel terrible for McCarthy. He called up his broker, saw Procter & Gamble trading in the low $60s, and then tried to sell his shares. He ended up taking a $15,000 hit on a transaction that netted him $29,000 instead of around $44,000. Although McCarthy's terrible experience happened within the context of issuing a market order for Procter & Gamble, it touches on a broader principle I'd like to discuss: the act of selling a stock merely because the price went down.
If you read the full story of McCarthy's narrative, you will know that he became "skittish" by movements in the market, and got worried that the "big boys" were going to drive the stock prices lower. I hope you do not think like that. And I do not say this to pick on McCarthy - he had a dose of bad luck that he did not deserve. No one should look at a stock quote, see the company selling in the low $60s, and then find out that he sold it for under $40 per share shortly thereafter.
But I do want to discourage you from thinking that stock prices represent some kind of absolute truth. The stock market is just a giant auction house for businesses. A stock price does not tell you what the intrinsic value of the company is, but rather, it only tells you what other investors are willing to pay for an ownership stake in the business at a particular time.
Some investors automatically sell if their stock falls 10%. Others automatically sell if their stock falls by a certain amount greater than the S&P 500. The reason I do not take this approach to investing is because I would effectively be outsourcing my power to make informed decisions to others. And if I cannot trust my own judgments, what the heck am I doing owning individual stocks in the first place? If you sell your stock simply because its price went down, you are effectively saying, "Others know something I don't." I didn't get into investing so that I could outsource to others the power to determine value.
Instead, when a stock price falls, I ask myself: Did the long-term earnings power of this company experience a commensurate decline?
My thought process isn't: Uh oh, Chevron fell 25%, time to sell. Rather, I'd ask myself: Did the long-term earnings power of Chevron decline by 25%? If I conclude that the long-term earnings power of Chevron did not decline by at least 25%, then the stock got cheaper. If I conclude that the earnings power of Chevron fell by about 25%, then the price decline was rational (and it may be time to consider selling). And if I conclude that the long-term earnings power of Chevron fell by more than 25%, then the stock actually got more expensive, despite the severe decline in price.
The point of thinking this way is that it keeps the judgment calls within your hands. Selling a stock just because others are driving the price down involves abdicating your responsibility to judge a company based on its fundamentals. A price decline is only rational if the company experiences a deterioration in its fundamentals (unless the company was overvalued to begin with, or an extrinsic event occurs such as rising interest rates).
There is one huge benefit to thinking this way: it makes it so much easier to ignore folly when other stock market investors are losing their minds. For example:
When IBM (NYSE:IBM) was falling from $130 to $82 during the financial crisis, an investor that chose to focus on the fundamentals (rather than what other people were doing with the stock prices) would have seen his share of earnings and dividends grow.
When Coca-Cola (NYSE:KO) was falling from $32 to $18 (on a split-adjusted basis) during the financial crisis, an investor that chose to focus on the fundamentals (rather than what other people were doing with the stock prices) would have seen his share of earnings and dividends grow.
When Colgate-Palmolive (NYSE:CL) was falling from $82 to $54 during the financial crisis, an investor that chose to focus on the fundamentals (rather than what other people were doing with the stock prices) would have seen his share of earnings and dividends grow.
The big secret to investing is not selling when prices are falling. Other things matter, to be sure, but if you can avoid that pitfall, almost everything else will take care of itself. If you only consume 1,500 calories per day, it's hard to get fat. Sure, there's a lot more to health than that, but limiting caloric consumption goes a long way towards healthy living. The best way to avoid selling low is to maintain your power to think. Look at the operating results of the company. Don't defer to the wisdom of crowds and assume that a 20% decline (or whatever it may be) should be an automatic sell signal. Reach that conclusion yourself by judging the company's fundamentals. The greatest gift we have is the power to think. Don't let someone else do that for you by automatically selling in response to price declines.