7 Suggestions For When Your Stocks Fall

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Includes: ATVI, JD, QQQ
by: From Growth to Value
Summary

Even though this bull market has been great for a lot of portfolios, there are also big losers: General Electric, JD.com, Activision Blizzard.

How should you deal with these huge drops? Do you sell? Why (not)?

I present seven suggestions of how to think if your stocks are down.

Learn how to dollar cost average on steroids.

Introduction

This bull market has been bringing wealth for investors for almost 10 years now. Pundits sometimes refer to it as 'the most unloved bull market ever', because it was a rather slow process sometimes. But that title seems to have disappeared after the current bull market became the longest in history at the end of August 2018. It has had an enormous run since the trough of the Great Recession in March 2009:

Chart SPY data by YCharts

But that doesn't mean there hasn't been any stress for stock holders. There were quite some crises along the way: the Greek tragedy which almost caused the euro zone to collapse, the oil prices that kept falling in an oil war between the US and OPEC, a U.S. credit downgrade, hostility from North-Korea, the Brexit, recently the trade tensions with China etc. But the bull market has overcome all these problems so far.

A lot of investors, though, felt the pain of at least a few big losers. What to say about the shave investors in General Electric (GE) received over the last two years?

Chart GE data by YCharts

Or the stockholders of JD.com? (JD) (me being one of them), the worst performing stock of the Nasdaq 100 (QQQ) in 2018?

Chart JD data by YCharts

There are numerous other stocks who have had the same pattern. This is Activision Blizzard's (ATVI) stock price evolution over the last two months:

Chart ATVI data by YCharts

Again, this is a stock that is in my portfolio. But I don't care, actually. The reason is that I invest for the very long term, expressed rather in decades than in years. In this article I hope to convince the reader that you shouldn't care too much too and I will try to let you think about your own investing principles.

The reason is that even if you don't have huge losers now, you certainly will be in it in the future. As certain as death and taxes, there will be a new bear market some day. So you too will become like a JD, ATVI or GE stock holder.

1. The stock price is not the company

The stock price is not the underlying company. It is not because the stock price goes down that the company is worse all of a sudden, although a lot of investors seem to think so. Sometimes small misses cause enormous drops, but that doesn't always mean that much. It is often just noise.

I hate the expression: 'The price tells me that...'. Price simply doesn't communicate, it is the people saying that awful sentence who interpret the price and attach stories to it.

We are all story tellers, if we like it or not. And that also makes our lives more beautiful. It only gets dangerous if we believe that our stories are the truth and nothing but the truth. Even though some investors don't like it, nothing in investing is certain; that is also the reason why the average return is higher than in more certain formulas like bonds or a savings account. You take the risk of losing money to win more money. But because of the uncertainty, people need a story to hold on to. It is what man has been doing from ancient times: if you don't understand something, make a story that people can believe. Think of the old myths about the sun or the moon. Or the myths of the Greek, the Vikings or actually any culture. That includes the stock subculture.

Stock prices only tell you something about the sentiment that investors have about a company, but it doesn't necessarily tell you something about the company itself. If the story around the stock changes, often people change their point of view, but that is often on second-hand sources, coming not from the company. but from other investors, analysts, friends or even rumors.

You can compare it with the next situation. From now on, the chief editor of a big newspaper decides to report about every vehicle crash. Most people would believe there are much more accidents, while it is only their perception that has been influenced. In the same way, investors often don't look at the original source (the company's statements and files) but at sentiment and negative reports by others about the primal source. As Benjamin Graham, the Dean of Wall Street, said :

(Source)

2. Take your distance

If there is a bear market, a lot of investors sell. They have a pain threshold. Some say that it is around 20%, others say it is 25%, others only 10%. It isn't that important. For those who are afraid of a correction (-10%): only a minority grows into a bear market (-20%):

From 1900 through 2013, there were 123 corrections (about one per year) and 32 bear markets (one every 3.5 years), according to Ned Davis Research.

(Source: CNBC)

Since the end of the Great Depression in the 1930s, only five bear markets reached drops of 30% or more. That is only one every 17 years on average.

It is also a strange phenomenon. Could you imagine that you are shopping in a supermarket and through the supermarket's sound system a voice announces that everything is now off 20% and a lot of products even more and from the moment the announcement is made, all shoppers rush out in sheer panic? When they hear on the radio later on that prices have normalized, they sigh in relieve and go back to the supermarket. This is really absurd, I know, but it is what a lot of investors do in the stock market.

Warren Buffett is afraid of bull markets, not of bear markets:

The best thing that can happen from Berkshire's standpoint … over time is to have markets that go down a tremendous amount," he said. "We are going to be buyers of things over time. And if you're going to be buyers of groceries over time, you like grocery prices to go down. … What we fear is an irrational bull market that's sustained for some long period of time.

(Source: CNBC)

I think that investors should take a step back before taking any action and consider their urge to act. Mostly it will be emotionally motivated, not rationally. If that is the case: make it a very clear and strict rule that you don't do anything.

Always look at this graph before you have plans to sell:

(Source)

It has helped me a lot to look at this graph (and variations of it) in my first few years of investing, although I still made some rash and stupid mistakes, despite my desire to act more rationally than the average investor. It also makes it easier to ignore the comments of bears ('Told you so'), previous shareholders of a stock ('Good thing I sold everything') and downgrades after the drop.

3. Try to look into the future

Investing is forward-looking. That also means that you should try to catch the big trends in society. But don't hurry, they play over a longer period than you might think. The first investors are not always the best investors. Make sure you know it is a long-term trend before you put your money into a trend.

The typical pattern of the hype cycle always plays a role for investing too. The hype cycle is a visual model used by the research firm Gartner that represents new technologies in a chart with visibility and time as the axes. The general model looks like this:

(Source: Wikipedia)

Often the hype cycle is also reflected in the evolution of stock prices. The premium example is of course the dotcom bubble at the end of the nineties. Internet and everything related (software, chips etc.) was inflated to irrational prices at the Peak of Inflated Expectations. Then came the bust and the disappointment in the Trough of Disillusionment where the negativity around internet-related stocks was very so profound that the market steered clear of all tech stocks. That was needed to grow and get on the Slope of Enlightment.

This is the hype cycle for 2018, with a lot of technologies in different phases:

(Source)

But looking at the future is more than just looking at what technology will break through within a few years. As I pointed out in my last article about Shopify (NYSE:SHOP), self-employment, full-time and as a side hustle, is a big social trend now, which will only become bigger and bigger.

Another one, that I have already pointed out a few times (in my last article about JD.com (NASDAQ:JD) for example) is that China will become the biggest economy, taking over from the USA somewhere between 2025 and 2032. Investors should take action, in my opinion, to be prepared for these big trends.

Are there any other big trends that you see? Feel free to share them in the comment section!

4. Look at your portfolio as a whole

A lot of investors only focus on the losers in their portfolio. They tend to try to do something, to 'solve the problem', to 'get the dog out', to 'cut their losses'. Or worse, they sell their winners to average down in their losers. These investors are victims of the disposition effect. That is the tendency investors have to to sell their stocks that have gone up, while keeping those that have dropped. Water the weeds, not the flowers, as it were.

What I do to solve the problem is simple: I have a strict rule of not selling. If a stock goes to zero (which is quite rare), then I have lost 100% of my money. But if it goes up, it can go up by thousands of percentages over time, wiping out tens of losers. You can read more about this in my article 'This Is Why You Really Should Have Growth Stocks In Your Portfolio'.

I know that a lot of traders fence with the term 'opportunity cost', but I think that is bogus. As an investor it is impossible to have a pick rate of 100%, so you always have opportunity cost, no matter what you do. Traders' trading costs are also 'opportunity costs' in my opinion.

Traders often sound very confident and even on the verge of being macho (some over the verge of it) about the stock market, the direction it will take, the stocks and sectors to buy and almost all other things. I think the reason is that they have to to convince themselves. They spit out great results and cite stock in which they have won 100% or more in a short period of time. These results are impressive, of course, but they mostly don't paint the full picture, because most traders leave out their losers.

You may have heard that 95% of traders lose money. It is a popular sentence, but is it true? According to research, the number is actually even higher: the average active trader under performs the market by 6.5% every year. And less than 1% of traders are able to earn money after all costs are deducted. Most traders act because of a desire to be entertained: action is more interesting than sitting on your hands, but often less successful.

So don't fall into the 'opportunity cost' trap. All investing is imperfect, but trading too much is even more imperfect. As long as you have a diversified portfolio of 15 to 20 stocks at least, you will probably have more winners than losers if you invest for the long term. The losers will become tiny positions, while your winners will be big positions of your portfolio.

Yes, you could take some profit from the huge winners, but I would advise to do that only if a winner position becomes too big a part of your portfolio. How much is 'too big' is up to every individual investor, but for me, I still feel comfortable if a stock reaches 20% of the total worth of my portfolio. With 20% and 20 stocks, you have a huge winner and you let it run, which is the way to do well in the stock market.

5. A paper loss is not a loss

When faced with paper losses, many investors feel bad, but they shouldn't. After all, as long as you don't sell, you haven't lost money. And, as we have already seen, the price of a stock often doesn't say anything about its underlying value. The stories around stocks, as for example made by analysts, are often just confabulation, stories to explain away something.

The Korsakoff syndrome is a memory disorder that affects short-term memory. Studies have shown that patients make up stories to explain certain things they don't remember at all and are really convinced that these stories are the truth. They can become very angry if you say the stories are false, although they clearly are. In that sense a lot of investors make me think of Korsakoff patients: they make up stories for what they can not know to get a grip on reality and just as those patients they get angry when someone confronts them with the truth or with the fact that it is impossible to know.

Another bad coping strategy is projection: blaming someone, anyone, for the loss. Most often investors single out the CEO. These investors forget that the same CEOs have often brought the company to where it is now. And even though it is possible that a CEO loses his knack or was not a great choice in the first place, it is also possible that he simply is the victim of bad luck, a temporary slowdown in the niche of his company's market, the loss of talent that spread its wings, a market sentiment change and so many more possible causes of a market underperformance.

If I have a permanent loser, I leave it in my portfolio, as a reminder that I can fail because of my biases. And everyone has got them, be assured. Lots of investors keep making the same mistakes over and over again. Your paper loss can be a reminder for those mistakes, since you see it every time you look at your portfolio. And it is a reminder that you can not be right all of the time. Hey, I still have Celgene (CELG) and Gilead (GILD) in my portfolio. They are reminders that investing in biotech it is often all or nothing and that cheap valuations of biotechs are sometimes just a sign of the top in sales of a certain drug.

Taking a step back and considering your own investing as if it were from another investor is very interesting too. Was your portfolio diversified enough? Did you take the right decision with the facts that you knew then? What can you learn from this loser? Be honest and do it with as little feelings involved as possible, as you can do to someone else's portfolio. But also accept that you can never be always right. Losing stocks in your portfolio are just a part of the nature of investing. Don't deny nature.

6. Reconsider your process

When you bought a stock, did you do that because of well-though out reasons or was it on a sudden impulse? Most people will think that there is no doubt that the well-thought out decision is much better, but often it isn't. I already mentioned Malcolm Gladwell's excellent book Blink, The Power Of Thinking Without Thinking in my previous article because I was explaining about biases there. Malcolm Gladwell, Blink, Power of thinking without thinking

(Source: Amazon)

In his book, Gladwell writes about several studies that show that we actually perform better if we don't think rationally. That may sound strange to a lot of people, but the results of several tests have shown this firmly and consistently. Probably you can understand that in sports: thinking is a delay and weakens your performance. But thinking might have a negative influence in certain decisions in investing too, I think.

A famous example of the negative influence of thinking is the jam test. It is a psychological test that was done by Wilson and Schooler in 1991. The researchers took the 1st, 11th, 24th, 32nd and 44th best tasting jams according to the public and specialists and gave them to the students. They could taste and then rank the jams and they did very well, mostly closely mirroring the ranking.

But when another group of students was asked the same thing (to rank from good to less so), but they had to think about the jams (consistency, sweetness, spreadability etc.) and argue why one was better than the other. These students had to fill in questionnaires. What they did was a surprise: they actually chose the worst jam as the best now. The reason?

Wilson and Schooler argue that “thinking too much” about strawberry jam causes us to focus on all sorts of variables that don’t actually matter. Instead of just listening to our instinctive preferences, we start searching for reasons to prefer one jam over another. For example, we might notice that the Acme brand is particularly easy to spread, and so we’ll give it a high ranking, even if we don’t actually care about the spreadability of jam.

(Source: Wired)

I think the same goes (partially) for stocks, actually. Rationality is overrated: often investors focus on metrics that don't matter at all. But the sad thing is that intuition, which is underrated, is by definition not explainable to others. You can win over very few people by saying that you have a gut feeling about a certain stock, but can't explain it. But when we do, we should take this seriously.

I have ignored my gut feeling about Amazon (AMZN) for years on end because all the metrics that I thought were important were not favorable: P/E, PEG, margins etc. Eventually I have bought shares at $800 in the beginning of 2017, but not buying a decade earlier is probably the worst investment mistake that I have made (so far). And it is not the only one. I have had an eye on Veeva (VEEV) for years, but I still don't have it in my portfolio. I even set a buy order at $24 at the end of 2015, but it didn't reach that price for a few weeks, which made me cancel the order. Veeva is at $93 now.

The common factor in these two stocks is that my gut feeling said that these companies were the future in their markets. I still think of JD.com now, so I will certainly not sell the stock. But I will not fall in love with the stock in case there would be things that I miss.

Humans can only consider four different variables at a time, according to research. If there are more variables and you start to break them down into smaller parts, you are prone to fall victim to 'the jam problem': rationalizing and doing a worse decision therefore. Be aware of those facts as an investor.

There is one exception to the rule that if you rationalize less, your decisions are better. That exception explains why investors are always encouraged to act rationally. The exception are experts.

If you have worked long and hard in a certain area of expertise (and we are talking about years and years here) your rationalization will improve your results, because you have internalized all the different elements in your system. Warren Buffett, Ray Dalio, Peter Lynch and so many more known and unknown successful investors with great experience do have an advantage over the average investor in that sense. They are able to act rationally and by doing so improve their investment process.

Buffett bought his first stock when he was 11. Buffett started buying Berkshire Hathaway (BRK.A)(BRK.B) shares in 1962, when he was 32, so he already had an experience of 20 years. And it was 1967 before Berkshire began investing in other companies. Buffett had a partnership before, which started in 1956, but even then he already had 15 years of experience as a 26-year old.

As long as you are not an expert, with years of experience, you should be aware of your gut feeling and listen to it. Because, the strange thing is that the less information we have, the better our predictions are. But we gather more and more information, often making our decisions less and less qualitative. This is called information bias. To learn more, I refer to the Wikipedia page.

7. Good old DCA, but on steroids

Dollar cost averaging or DCA is an old technique and it is very simple: invest the same amount of money every same time period, no matter what the market does. For example: $100 each week, $500 dollar each month, $2500 each quarter or whatever your equivalent is of about 10% of your income.

The reasoning is simple: if the markets are high, you buy less shares for a fixed amount than if the market is low. If you invest $200 every two weeks and a stock cost $50, you can buy four stocks. If that stock falls by 50% to $25 two weeks later, you can buy eight shares of the same stock. Your average price is then $33,33, closer to the lower end because you buy more shares then.

Statistically, lump sum investing works better than DCA. That is because the markets go up more than they go down. But statistics don't count for individual investors. A lot of unfortunate people have drowned in a river of statistically one meter deep. So DCA is a good strategy to prevent that you invest just at the moment before the market crashes, wiping out a lot of your money for years to come.

But I have a system that I use to boost the effects of DCA. I call it DCA on steroids. If the market falls by 10%, I add 20% more money to my account than ordinary. As long as the price stays is under that 10% mark (but not above 20%) I keep adding 20% extra.

A 20% drop? I add 50% extra money to my account. 30%? I double my monthly amount. 40%? I add 150%. 50%? I triple my money. I don't have a scenario for 60% or more, since I don't expect that to happen. Mind you, I don't add the money on margin. I just try to save a bit more in those months.

With this system of DCA I can take advantage of the sales that a market sell-off provides. By buying more because of the system of DCA and then adding even more money, it is a double boost for your portfolio. It is a very simple system to turn up your profits.

Conclusion

Even though the bull market has been going on for a while now, individual stocks have plunged during this period. In this article I gave you seven suggestions to think about if you have such a stock. The seven principles are not of the one-size-fits-all type. They are general principles to ponder about. If you want to become a better investor, it is important to think about the process of investing, not just the investments. I hope that my 7 suggestions can make you examine your own believes and biases.

If you have enjoyed this article and would like to read more articles for a long-term investor, please hit the follow button next to my name.

In the meantime: keep growing!

Disclosure: I am/we are long JD, AMZN, GILD, CELG, ATVI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.