It's easy to imagine picking up shares of your favourite ASX company when they're in freefall – creating value with every dollar lopped off that share price.
Unfortunately, in reality the experience of seeing this same company bleeding red can have a funny effect on your perception.
Often when a company is in the wars, there will be a barrage of negative news coverage that you might be bombarded with. You might get cold feet – asking yourself what all these investors selling out know that you don't. You might start thinking 'I'll just wait until it drops a little more' and before you know it, you've missed out on a 10% gain.
So let's take a look at why share prices fall, and what action, if any, you should take in response.
Why do share prices fall?
Basically, there are many reasons why a company's shares might fall in price. Investors might start to think a business will not be able to grow or even maintain its current level of earnings – either in the short-term or long-term.
A company might cut its dividend, which drives away investors seeking income from that company.
A company might be dragged down by general market pessimism – maybe during a recession or even a more short-term event like last week's Iran/US crisis.
What should you do if a stock is falling?
If you already own a stock, a significant share price drop isn't a time to panic, rather it's a time to methodically evaluate whether remaining invested in that company is a good long-term idea.
And if a stock is on your watch list and experience a sharp drop in price – it's time to ask yourself whether it's just short-term noise or a long-term structural issue that's causing the panic. If it's the former, it might be a great time to pick up shares on the cheap!
Investors who sold out of Commonwealth Bank of Australia (ASX: CBA) 18 months ago at $68 a share over fears from the Royal Commission would be feeling a little silly today, I'd wager (CBA shares are currently trading north of $80).
But anyone who sold out of Fairfax Media shares after it became clear what the internet was doing to the newspaper industry is no doubt comfortable with that decision. For context, Fairfax is now owned by Nine Entertainment Co Holdings Ltd (ASX: NEC).
Foolish takeaway
Recognising the difference between short-term problems for a company and long-term structural changes is the most important thing to focus on when your favourite company drops in value. One is an opportunity for a bargain, the other is a value trap. Knowing the difference can help you boost returns and cut losses early – so keep that in mind when the next 'dip' comes your portfolio's way!
