Perhaps the one single aspect of the stock market that tends to scare people the most is the sight of a falling stock price. Nothing can scare away a newbie investor more than finding out that the shares he or she bought are sliding into the red the next month, day or even minutes after the buy order was placed. If this is what you are seeing relax a little. There are many strategies that involve dealing with the stock market some are long term strategies like value investing and dividend growth investing while others are short term strategies like day trading and range rebound trading. If you are a long term investor like me and you are seeing your shares sliding into the red take a deep breath and relax for a moment.
A falling stock price can be the result of many factors most of them don’t necessarily mean that the company is going bankrupt. Any bad news about the global economy or any country in general is enough to send the whole market into the red zone. Remember that the stock market like any other market works under the law of supply and demand. The stock market has been notorious for its wild up and down swings which range from small corrections to crashes and the bull and bear cycle. There is nothing that can be done to stabilize the market. It feeds itself from pessimism and optimism. What are really important are the fundamentals of the company in which you own shares. For a short term trader a falling stock price might be a reason to panic and even cry but for a value investor or a dividend growth investor it might be the equivalent of a black Friday shopping spree for a consumer.
The first thing to look at is at what is happening in the market as a whole. Are the Dow Jones, S&P 500 and NASDAQ down? Many times when you notice that your stocks are going down is because a market correction is happening or there are some news articles about the economy that made investors, which are most of the time traders, panic. If you see that most indexes are going down relax. It’s just how the market reacts to any bad news. It is very probably that the company that you invested in is doing just fine. Like I said before, what is important is that the company’s fundamentals are healthy and that it remains profitable. A good and profitable company is able to survive mostly any calamity and make money for its shareholders over the long term.
The effects of dividends and buybacks when the price of a stock goes down
Assuming that the company is doing well a falling stock price might give rise to more profits in the end. Companies that have share buybacks in place can easily buy back more shares because of the cheaper price therefore, returning more ownership to shareholders. In case of dividend paying stocks, the rise in earnings per share will probably result in higher dividends down the road and if the stock is enrolled in a dividend reinvestment program the reinvested dividends will buy more of the company due to the lower price per share which will also make dividends grow faster. As a result the yield on the initial cost of the investment will climb faster than usual. Remember that all of this is assuming that the company is generating good profits and that the falling stock price is not because the company is starting to lose its grip.
When can a correction be disastrous to your wealth?
In the middle of a correction a lot of stocks ranging from sectors to the whole market go down in price. The effects of a correction on an investment can be devastating depending on the particular circumstances of it. An investor that buys a stock that is overpriced can be obliterated after a correction. The key word here is price. A stock that was bought at a fair price or undervalued can easily climb back to its previous levels over the course of time but one that was overvalued at the time the buy order was place may take years to reach the breakeven price or even worst never reach the break even price at all. You have to be careful when your buy an investment especially if you notice price to earnings ratios of more than 25. Some growth stocks might have a very high price to earnings ratio because they have been growing at a tremendous rate most other growth stocks are subject to more speculation than actual growth especially after an initial public offering. Again, the price paid relative to earnings is the most important factor after fundamentals. A fair priced company with good fundamentals might be the best investment you will make after a correction or market crash that sends it into the undervalued zone. Legendary investor Warren Buffett is known to go on stock shopping sprees after corrections, crashes and during bear markets because he understands the companies he invests in and their fundamentals, knows that current market conditions are temporary and buys when the price is right. This approach is perhaps the most important aspects of value investing, dividend growth investing and even range rebound trading. Buy low and sell high don’t forget it.
When a falling stock price means trouble
Sometimes a falling stock price signals trouble up ahead and not investor related panic. To determine if the price of a stock is falling because of something more serious you have to read annual reports and 10Qs. Are profits going on a down trend? Is the product or service becoming obsolete? Is the problem permanent of something temporary? These are some of the questions that you should ask yourself when reading documents from a company whose stock is falling in price. If you think there is serious trouble brewing it might be time to sell a losing investment. Remember than you lose money if the amount you received from selling an investment is less than the amount you initially invested. You have lost no money if you haven’t sold your shares even if the price is lower at the moment.
My dividend stock passive income strategy:
As a value oriented dividend growth investor I try to find companies that have durable competitive advantages and that offer products that are staples in everyone’s daily life. I wait for a market correction or a downturn and buy stocks when I think the price is decent. Since I take dividends and their growth as part of my main passive income strategy, a lower price gives rise to a higher dividend yield which is one of the things I look for. Other aspects of a company that I look for is a good dividend growth rate, increasing earnings per share over many years, low debt, good margins, a return on equity of more than 20% and that the company is buying back its shares. As long as the company remains in good shape, sends dividends that grow each year, doesn’t go crazy accumulating debt and has higher earnings per share each year; I ignore how the market treats the stock after the purchase and enroll it in a dividend reinvestment program.
Photo credit:renjith krishnan.