How to Respond to a Stock Drop: Winning Strategies for Investors

Sometimes a stock goes south after you've just bought it. Other times, you've owned a stock for a long time, having made a substantial capital gain, and then it starts to plummet too. In both cases, you find yourself borrowed, without really knowing what to do. Should you buy even more to take advantage of the cheaper price? Or sell to avoid more losses (stop loss)? Or simply do nothing?

Most of the time, the latter is the best option. Prices are erratic in the short term. They move for reasons that have more to do with crowd psychology than the intrinsic value of companies. If you sell at this time, there is a good chance that the price will go right back up. Buying can be an option, but it also means increasing your risk by concentrating more assets in one position. Even if prices follow a random path in the short term, sometimes they fall for good reasons.

Check the fundamentals

In any case, it is necessary to check whether something has changed in the fundamentals. As long as these are positively oriented, there is generally no cause for concern. A check of the balance sheet and annual results is in principle sufficient to form an opinion. Profits are inherently inconsistent, especially in the short term. It is therefore neither useful nor even desirable to focus on quarterly or half-yearly results.

What does it mean to check the fundamentals? Here are some examples of simple questions to ask yourself:

• Is the company making a profit?
• Does it generate positive free cash flow?
• Are profits increasing (or at least stable)?
• Is the dividend increasing (or at least stable)?
• is that the distribution ratio is less than 70% (compared to profits and compared to free cash flow)?
• Is liquidity increasing (or at least stable)?
• Is the margin increasing (or at least stable)?
• Is profitability increasing (or at least stable)?
• Is long-term debt decreasing (or at least stable)?
• Is the number of shares outstanding decreasing (or at least stable)? 

The more positively you answer these questions, the more likely it is that the market is going crazy for the wrong reasons. So you have every chance on your side that the stock price will quickly get back on track. But sometimes the market may take a long time to recognize its mistakes. Or it may have been right, anticipating a change in fundamentals thanks to inside information. It is behind this last argument that chartists hide to justify that there is no point in analyzing company balance sheets and results. According to them, all the necessary data is already in the prices.

Momentum effect

Research has proven the reliability of the fundamental “value” based approach. Technical analysis, on the contrary, has never clearly succeeded in demonstrating its effectiveness until now, with one exception: the momentum effect. A stock that has outperformed or underperformed over the last six or twelve months has every chance of doing the same in the following six to twelve months. This effect is limited to this duration, because beyond that, the opposite happens. This effect would be due to the propagation time of information that starts with insiders and ends up with the mass of investors.

This means, in the case at hand, that it is possible that negative events, likely to have a lasting impact on the company, start by causing the share price to fall before they become known to the general public, and that this effect also continues for several months afterwards. In total, this process can take up to two years, if we add up the 2x12 months of the momentum effect.

So how can you protect yourself from this problem? Even if you have controlled the fundamentals, you are not immune to a situation of this type. Following quarterly reports will not change much (you will not have the information before the market). On the contrary, it can even worry you wrongly because of the inconsistent nature of short-term profits.

Stop Loss

This is where chartists can paradoxically help us. Traders apply the 2:1 rule. In other words, if they expect to win 2$, they should not lose more than 1$. This ensures that losses are limited compared to potential gains. To do this, they set a sell order of the "stop loss" type, which in this example is 1$ below the purchase price and a sell limit order 2$ above the purchase price.

We understand quite well how this works for traders, on small price movements during the day, or even over a few days. But how can this principle be applied to long-term investors, who expect potentially unlimited gains, or at least of several hundred percentage points? Even assuming that one aims "only" to double one's investment within seven to eight years (which is a completely reasonable prospect), one should set a stop-loss order at 50% below the purchase price. This of course makes no sense.

That said, research has shown the effectiveness of stop loss orders placed 20% below the purchase price. This strategy is even more effective if the stop level is adjusted proportionally as the stock price rises ("trailing stop loss"). With this method, we can simultaneously reduce risk while increasing performance.

Why sell?

This approach may seem a bit unnatural for a value investor. I have personally wondered a lot about this. Why sell a stock, sometimes at a loss (if the stop level has not had time to rise to the purchase price), when the fundamentals are still good? There are two reasons that can explain why this strategy works:

• Even a solid company stock can be battered for long periods. By "exiting" the position when its momentum is bad (loss of 20% or more), you generally avoid a long crossing in the desert. You reposition your assets on other better oriented stocks, which have a good chance of doing better than the one you abandoned. There is nothing to prevent you from returning to them later. This essentially explains why this approach allows you to increase the performance of your portfolio.
• Sometimes the stock falls for very good reasons, which are not yet known by the market. By exiting the position at 20%, you limit your losses to this amount. When the bad news is fully integrated into the prices, the fall can end up being very brutal. This essentially explains why this approach allows you to reduce the risk of a portfolio.

Of course, this doesn't work all the time. It's all about probabilities. Most of the time, it's better to exit your position at 20% losses. But sometimes, you'll do it and the stock will come back very strongly right behind. It's only by repeating this principle several times over time, on several stocks, that you can really appreciate the validity of this principle.

"Manual" Stop Loss Strategy

To avoid false signals, it is better not to set an electronic stop loss or trailing stop loss order. These can be useful for traders who have a short-term investment horizon. In the long term, however, there is a strong chance that the market will "break down" at some point, for a moment. The price will collapse suddenly before immediately rising again. Triggering an order in this case would obviously be totally absurd. To do this, it is better to check on a regular basis, for example monthly, whether a security has lost 20% or more since purchase or since its last high. If this is the case, then it is sold "manually". The only risk then comes from the investor, who would not want to do it, for all sorts of reasons.

Conclusion

In short, if a stock goes down, we can say that:

• If the fundamentals have not changed unfavorably and the price has not fallen more than 20%, there is no need to worry.
• If the fundamentals have changed unfavorably or the price has fallen by more than 20%, it is worth selling the stock.

This strategy requires a little more work than a pure fundamental approach, with analysis of balance sheets and results once a year. You must therefore be prepared to monitor the evolution of the prices of your securities on a regular basis, i.e. once a month. You must also be psychologically prepared to get rid of securities that you bought for very good reasons. These are still relevant when you have to sell them. This approach is therefore much more restrictive not only in terms of time, but also, and above all, in psychological terms. However, if you succeed, the game is worth the candle.