3 Common Mistakes Investors Make in Market Downturns

Opinion: General Manager of Wealth, Josh Callaghan

2018 was a choppy year in the markets and 2019 may not be dissimilar, given we still have Trump at the helm of the world’s most powerful country, Brexit still isn’t settled and we have a credit squeeze building in our local economy.

When the markets move against us, it can be a time where emotions start to rule and we can make some mistakes that are obvious in hindsight but not always clear in the midst of things. I put my hand up to say that I’ve personally made more than one of these mistakes myself during my decades of investing.

Mistake #1: Selling at the bottom

This can be a classic mistake we saw a lot of during the Global Financial Crisis (GFC). Often the more money at stake, the harder it is to avoid, as many investors start to wonder if the fall will ever stop.

It’s in these times that historical returns could be worth considering. The graphic below, by MarketIndex.com.au, shows the annual performance of the Australian share market, in terms of percentage total return and over the last 118 years.

 

View the full report here

As you can see, outside of the GFC in 2008, the market has only fallen between 20% and 30% three times and is predominantly (81% of the time) delivering a positive return over the course of a year.

There are two things that investors need to be mindful of to avoid selling at the bottom.

Firstly, avoid measuring off the high

Everything seems more dramatic when measured against the high-tide mark of a stock price. When the ship feels like it’s sinking, the two points that I hold onto are the price I bought the stock at and the 12-month average price. These provide a more level-headed view of how much your portfolio has actually moved. If you’ve been holding the stocks for a while and have been receiving dividends, then you may want to include that in the calculation as well.

For example, if I have $1000 worth of shares over 10 years that have paid out a 10% grossed up dividend each year then I’ve received $1000 in dividends and the initial outlay has already paid itself back. If those shares are now worth $500 then I’m still ahead.

Stock market crash
When the stock market’s down, do your emotions get the better of you?

Second, do the maths

Often the market can have an indiscriminate sell-off due to factors not necessarily related to the individual stock you’re considering. When the price of a stock goes down, keep crunching the numbers to try and come to a value of the company.

The questions you may be looking to ask in these times could include:

  • Has the business model fundamentally changed?
  • Has the book value of the company changed?
  • Is there any new information that makes me consider deviating from my original valuation of the company?

If there isn’t anything material that has changed then it may be a good time to hold on and ride out the downturn. In fact, you may even want to consider a strategy called dollar-cost averaging while the price is moving down.

Remember, once you sell a stock you are locking in any gains or losses that you have accumulated up to that point.

Mistake #2: Not selling at an opportune time

Of course, individual stocks don’t always just drop with an overall market correction like the GFC. They can also be sold down due to specific industry or company-related issues. In 2018, we saw this in the price of the banks. Off the back of the Royal Commission, where significant failures within the industry were uncovered, the likes of AMP and IOOF saw their market value plummet.

When specific stocks have declined further or outside of their peers or industry, then it generally means that something has changed in the way that other investors are valuing the company. It’s at these times that revisiting your narrative around this stock is important. Why did you originally invest in the company, what are you expecting to happen to create further value and have any of these factors changed?

If your narrative no longer holds true then it may be time to re-evaluate that stock. Warren Buffett once said that his favourite holding period is forever. However, as the fundamentals of a company and environment around that company change, so does his evaluation which may lead to a decision to sell the stock.

 

Market downturn mistakes
Have you made these mistakes?

It’s never easy offloading shares at a loss, but doing it where necessary may be one of the most important disciplines that investors need to learn. If your assessment of the company has changed for the worst and you have ongoing concerns, then not selling could leave you open to:

a. further losses as the stock may continue to decline over time; and

b. those funds being tied up in a stock that has limited growth or earnings potential when it could be put to work in a better performing stock.

However, not all stock-price-declines mean that the company has lost its ‘mojo’. If you redo your sums on the company and find that they still look good, then it may be an opportunity to buy more of a great stock at a low price.

Mistake #3: Bargain shopping without prior research

Buy low and sell high, that’s a common mantra of stock investors. So, does it make sense to jump in on a stock if its price has been beaten down? Short answer: not necessarily.

Really this point is the summation of the last two points – don’t make decisions on price alone. Instead, do your research. To this point specifically, I think about the difference between growth and income stocks.

One of the challenges with pricing growth stocks is estimating the value of future opportunities, such as penetrating a new market or launching a new product. This can cause a growth stock’s share price to move around dramatically, particularly if they’re already trading at a very high price-to-earnings (PE) ratio. In 2018, Afterpay was a good example of this where the price was, in my opinion, oversensitive to both related and unrelated market news because there were so many growth assumptions built into that price. For more on that, have a look at my earlier assessment of Afterpay.

Stock market mistakes
Common investing mantra: ‘Buy low and sell high’

 

The point here, though, is that following the ups and downs of the stock price in high-growth companies can provide opportunities to buy at a valuation that you’re happy with. Maybe the price never gets to what you deem as reasonable, and that’s okay too, as it will keep your money freed up for other opportunities.

Share price declines in large, quality companies with a history of paying dividends could also present a buying opportunity in some cases. As their share price goes down, their dividend yield goes up, as dividends are paid in cents per share. Provided the company’s ability to pay dividends at the same rate isn’t impeded in any way and the fundamentals of the company are still strong, then investors may be able to walk away with a high-yielding, quality investment.

To sum up

The three points above may seem a little contradictory on first glance – don’t sell unless you should and don’t buy unless you should. But they all hinge around one central point which is to not necessarily just follow the market without doing your research. When the market is determining the price of that stock, industry or sector it can be for a whole host of reasons that aren’t always related to why you’ve purchased the stock or why the stock is ‘good’ or ‘bad’.

Perhaps it should be summarised as something like this: don’t buy or sell based on price movements alone. Instead, re-evaluate the opportunity in light of the new price and decide to sell, hold or buy on that basis.


About Josh Callaghan
Canstar’s General Manager for Wealth, Josh Callaghan, has accumulated more than 15 years’ experience in banking and finance, with in-depth product knowledge across retail banking, stockbroking, life insurance, health insurance and superannuation. Josh’s experience combined with his passion for new technology and active role in the fintech community has positioned him as a credible thought-leader on the future of finance. Through his work at Canstar, Josh is striving towards a goal of creating a world where building and managing wealth is easy for all consumers.

Follow Josh on Twitter: @CallaghanJosh

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