It's a question every investor will have to answer at one point or another: What do you do if one of your stocks sees a big drop in value? Do you wait out the downturn, double down on your thesis or cut your losses and sell? Making the wrong choice means losing money. Staying in risks further losses, while getting out risks missing out on a recovery.
There's obviously no one-size-fits-all answer to this question, but you can make your decision easier if you start by answering a few questions. First, why did the stock decline, and does that reason reflect on why you bought it in the first place? Let's say you bought a company because of its high dividend yield. If the dividend is cut, that's a reason to get out, especially if there's not another equally compelling argument in the company's favor. Obviously, dividends can be raised after being cut, but if your investment is already underwater, it could be a risky bet to hope that happens for you. A good investment rule of thumb is that if your thesis no longer holds, sell. There's no shame in admitting an investment didn't work out, and rebalancing is a healthy part of portfolio management.
As a corollary to the first question, look at the company's history. If it has been around for a while and has a proven ability to adapt to changing circumstances -- if it has a record of reinstating dividends when times improve, for example -- take that into consideration. The recovery potential of a stock like that is different than the prospects of a start-up with less of a track record.
On the other hand, if the stock has fallen for reasons that don't impugn your thesis -- if it is down because the overall market is down, not because of a problem with its fundamentals -- that's not a reason to sell. In fact, chances are very good that with time the stock will recover along with the broader economy. In a situation like that, you should hold tight or even increase your exposure, taking advantage of the discounted share price. If you have an extended investment timeline and a comfortable level of cash on hand, you can feel pretty confident that things will eventually turn around. When they do, you'll want as many shares as possible. For this reason, you should always reinvest your dividends as opposed to receiving them in cash; this is the easiest way to increase your holdings with no risk.
The important thing to remember is to remove emotions from your decisions as much as possible. Panic selling and impulse buying are never wise; even in scary environments like recessions or bear markets, it pays to keep your focus on long-term fundamentals, not daily swings. No one likes to see their nest egg depreciate, but the trend for markets is almost always positive over the long term. As Warren Buffett likes to say, "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."
Next week, we'll look at what investors should do when their investments see big rallies, a situation that may not be as scary, but can be just as tricky to navigate.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.