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Stocks: How to Catch a Falling Knife

Value investor with a deep passion for understanding and a desire to improve results over time.

stocks-how-to-catch-a-falling-knife

Free Fallin'

"Don't try to catch a falling knife." This is common wisdom among stock traders, and while lots of so-called stock market wisdom could be categorized as mythology, this simple phrase holds a lot of wisdom.

Prices decline rapidly in stocks from time to time, and it can be really dangerous to try to buy on the way down before prices have reached a bottom. I'll offer two different approaches to this problem, and having the ability to "change lanes" mentally between these two approaches will be enormously beneficial for you.

By switching gears between the mindset of a trader and an investor, you can take advantage of how Mr. Market operates.

Lane One: The Investor

So you're a value investor. You want to buy things when they're selling for less than their intrinsic value, and you'd like to do so with a margin of safety. That's really the only thing that matters to you, so buying any time a stock is selling for less than you think it's worth (and adding in the margin of safety) just makes sense.

An example illustrates this nicely: suppose that a stock is selling at what you perceive as "fair value" today, but you insist on a 20% margin of safety. Tomorrow, the bottom falls out, and the stock drops 25%. The stock is clearly a "buy" according to your metrics and definitions, so it makes sense to jump in and buy right now.

As a value investor, you don't really have an opinion on what the price will do tomorrow, so you have no way of knowing whether the stock will go down even further tomorrow or if your opportunity to buy this great business at a great price might go away instead.

So, you plunk down your hard-earned cash, invest in a business that is selling for a serious discount, and wait for multiple expansion while the market figures out the dumb mistake it has just made. If your time horizon is several years, and you're right about your valuation, there's a really good chance that you're going to have a solid return over time.

Issues

Buying before the "knife" has fallen all the way down certainly has the potential to yield impressive results. After all, if the stock valuation is right, the market is very likely to realize its mistake eventually, as other investors realize the same thing you've realized and gradually push the price up over time until institutions start to take notice of the movement.

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However, there are at least two issues with this strategy. Both of the issues have the same root cause: your cash will be tied up in the stock for as long as you're holding it. In practice, this means you can't buy something else with that money; it's completely tied up in the stock for the time being. In a nutshell, the amount of time your money is in a stock matters, and it matters a great deal. A 25% return is very good if you get it in six months, but it's not so great if it takes ten years.

The second issue, much more painful in the short term, is that you have no way of knowing whether a bottom is in and whether the stock might fall even lower. Take a look at the chart below, and let me know if you're pretty sure the bottom is in.

stocks-how-to-catch-a-falling-knife

Lane Two: The Trader

It can be useful to make a distinction about your strategy based on your time horizon. If you're thinking in terms of years, especially more than three of them, you're thinking like an investor. On the flip side, if you're looking to turn over your stocks more frequently, buying and selling over the span of months instead of years, your mindset is that of a trader.

Traders need to get their cash back from the market a lot faster than investors. Because of this central, defining fact, traders are a lot more sensitive to how long it can be before you get a positive return if you buy a stock on the way down. Market psychology and decades of data support this theory, and patient traders who jump in after a stock has begun a serious recovery will often be able to cash out much, much faster than a buy-and-hold investor who buys it on the way down, then has to wait for the bottom to be reached, and finally the realization of fair value by Mr. Market. One can grow old waiting for events like this to occur.

Best of All Worlds

If you're like me, and you just can't help yourself from buying something you've wanted to own for quite some time, there is hope for you. Instead of buying all at once when the stock is on the way down, try injecting an extra layer of discipline into your routine. Buy in tranches, cautiously observing the behavior over several trading days or weeks before you buy again.

If the stock has fallen another 20% when you buy your second tranche, and you're convinced the stock was a bargain when you first bought it, you are now getting an even better deal. You could consider one or two more tranches, but be careful not to use simple dollar-cost averaging since you'll whittle away all of your available cash.

By changing lanes between investing and trading and being extremely disciplined, you may well be able to catch that falling knife.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith

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