Stocks are down — what to do?

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I’ve lost a lot of money in the stock market recently.

I’m an optimist, but seeing a lot of money disappear isn’t the most fun thing. So after the latest drop in stocks over the past few weeks, I thought I’d share my thoughts here.

As I’ve written before, if you invest, you’re going to lose money at some point. That’s ok–especially when you’re young, because time helps mitigate loss if you have a good investment. But ideally, it shouldn’t be happening very often, and when it does, it still sucks.

Now check this out: I was listening to some personal-finance pundits talking about the recent down market, and more than one of of them said the equivalent of, “If a stock drops 8% (or 10%, or 12%), I’m out of there.” What the hell?

Here’s the example one of them gave. Try to figure out the answers before you go on:

“If your stock does down from 100 to 50, what percentage have you lost?

Now, to get back up to 100, what percentage does your stock have to increase?”

Answers: It’s gone down 50% and it has to increase 100% just to break even. (If it only increased 50%, it would be at 75.) Most beginning investors get this wrong.

It’s a good lesson, but I think one-size-fits-all advice is dumb. I went roaming around to find some data to prove otherwise, so check out this Apple graph I took from finance.yahoo.com:

Apple graph

Now, let’s just eyeball it. Clearly, the stock has done very well in the last few years. But let’s look at the period from 1995-1998, during which time Apple dropped from about 17 to about 10. That is a big, big loss of about 41%.

But because I cherry-picked this example to prove my point, I know that’s not the whole story. Apple closed at $67.98 yesterday, and it’s split twice since that low point in 1998.

Now there are a few things about this example: First, if you really think stock-picking is about looking at charts and guessing–especially retroactively–then you are going to lose a lot of money for being a moron. This is just a superficial analysis to give an example. Second, had you sold when Apple was down, you would have missed out on a lot of money.

“But Ramit,” you might say, “I wouldn’t know it was going to go up at that time! I did the best I could.” Well, true. In hindsight, everything’s clearer.

“But Ramit,” you might say, “when should I sell a stock then?” I’ve written about that here.

“But Ramit,” you might say, “what are you saying? You told us you lost a lot of money. So are you just going to let your money sit there? Isn’t this just an excuse for being lazy and overly optimistic that your stock picks are really good?” Now this is a good question. It’s possible I’m committing lots of cognitive and decision-making errors. What you need to ask yourself is, “Are these still good companies and good investments?” If so, and you have the risk tolerance and time to ride the storm, great.

If not, your options are more limited, which is why it pays to invest earlier. In fact, if you think the companies are good companies, they’re on sale right now.

* * *

I want to show you something that hardly anybody knows. It’s research from Standard and Poor’s, the S&P behind the S&P 500. In 2002, they released an astonishing finding that made most investors’ jaws drop: During a 10-year period they studied, if you missed the best days of that 10-year period, your returns would be cut in astonishing ways. For example,

  • If you missed the best 5 days of that 10-year period, your return would be down 22.65%.
  • If you missed the best 10 days, your return would be 37.65%
  • And it just gets worse for missing the best 15, 20, and 30 days of a 10-year period.
  • Here’s a pretty picture:

    Stunning finding from S&P research

    That’s from a PDF by Mercury Advisors, but you can find more here and here.

    If you think you can figure out exactly when those 10 days will fall in 10 years, then you are much smarter than I am. Don’t try to time the market.

    But don’t just sit around, either: If you suffer a relatively big loss in your portfolio (how big? you’ll know when it happens), it would probably be dumb to just saunter around outside with your hands in your pockets, whistling and skipping. Take some action:

    1. I spent part of last weekend doing an analysis on my current holdings to see if they still meet my investment criteria. (They do, except one company, which I’m not sure I would invest in knowing what I know now.)

    2. If I had properly diversified my investments, I wouldn’t have been hit as hard as I was. I’d been meaning to diversify into more non-tech stuff, including international funds, so I’m treating this as a kick in the ass to get this done. If you already have stocks, you can do this by either adding more money in different areas, or shifting current holdings to new areas.

    3. Also added to my to-do list: Writing about decision-making theory and cognitive biases sometime in the future.

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16 Comments

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  1. Personally I see stocks going down as a chance to buy more at a cheaper price. I would certainly not sell at a low price.

    But hey, I am one of those old fashioned buy low, sell high people.

    Of course there is the assumption in there that the price will rise again to its previous (faster than inflation).

  2. I prefer stocks that have both capital gains and income going for them.

    Sure the stock prices still fall (ouch) but at least I feel I get paid while I wait for the correction.

    I find a down market is a great way to measure the value of a company. A good solid company will decrease less than the index and correct faster.

    Plus of course, it’s time to go shopping!

  3. Totally off topic, but ramit, what are your thoughts on making money off Prosper(www dot prosper dot com), It’s a pretty interesting concept, but it’s pretty long term. Also there’s a risk if the person defaults but, if you spread it out…less risk.

    What do you think?

  4. My opinion is the amateur investor really has no business playing the stock market game. I played and I lost. It’s basically gambling if you don’t keep up with the companies your investing in. Every amateur investor should invest in index funds, they do what the market is doing and historically have done well. We aren’t talking crazy returns, but good returns that will beat any money market or cd. Another reason is most amateur investors don’t have enough money to play the stock market to diversify well. Index funds are are already diversified. I put money in Small Cap, Mid Cap, and Large cap with the bulk being in small cap (50%), then the rest is split between mid(35%) and large caps(15%). As I get older, I will change and put more into large and mid and less into small, as small caps can be the most volatile, but also have the biggest gain. That is my plan for the amateur stock investor, you can agree with this or not, but this has been working quite well for me since i got burned playing the individual stocks game.

    -Jeff O’Hara
    http://blog.zemote.com

  5. Brilliant post – I especially appreciate the part about the “best ten days”; far too many tend to only focus on the risk one is exposed to while being in the stock market, while not realising the risk of not being in the market when stocks are up. Thinking in terms of “dual risks” can be very useful!

  6. I don’t suppose you could dig up statistics on the cost of being out of the market on the worst 5/10/etc days?

  7. I think this post brings up the fact that most people worry much more about their selling decision — should I sell to cut my losses? or will it ever bounce back?

    I firmly believe that the buying decision is the more important of the two. Too many purchases by beginner investors are based on impulse, fleet of the moment.

    You also made a good point about staying in the market but a better question is why people are buying and selling so often in the first place? What’s driving them not to stay in the market?

    Playing devil’s advocate, yes, I’d like to also see the statistics on being out the 5 / 10 / etc WORST days as well. Bringing up those favourable statistics only serve to build your thesis. It’s like only surveying Chinese people if they like eating rice and noodles.

    My point is that stock investors can also be market timers too. Time your entry point.. your buy decision! What do you base your buying decision on?

    Most poker pros say that beginners get into trouble because they’re playing too many hands… they end up chasing cards and blaming it on not catching the river, but the flawed decision was playing with marginal hole cards… looking for marginal chances of victory. Sound familiar?

  8. Roman and Investorial, you can see the best and worst days from the link I posted in the article.

  9. I’m with Doug Brown on this one. It’s just a buying opportunity but I also tend to dollar cost average on managed/mutual funds and I have a significant investment horizon.

    Up, down, who cares? If it’s up, I buy less; if it’s down, I buy more.

  10. To follow up Investorial’s post check out: http://ycombinator.com/munger.html

  11. “If a stock drops 8% (or 10%, or 12%), I’m out of there.”

    I’ve been playing the stock game for over 15 years… There is truth in the above statement. You never know how far a stock will drop (or rise!). Do you really want to be holding Nortel… or Cisco… or Verizon. Or how about Enron, Worldcom, etc… Certaintly all those companies have (or had) what seems like valid business models. When a stock starts to drop, get out! You can always get back in if it starts to turn around. Now, using an example of Nortel… it may recover – eventually. But how long do you want to hold a dead stock? What is the oppurtunity cost of this?

  12. RJ – what is the opportunity cost of spending all your time buying/selling/trading/stewing/fretting/freaking over all of these single stocks? Pick a mutual fund with a good track record (10-20 years) and leave it alone. And stop watching CNBC all day.

  13. You have more studying to do. I’ve taken huge hits in the past, but not anymore. A skilled investor loses some money sometimes, but never loses a lot. To make the argument you’re looking for, you have to say the investor who knows fundamental value ignores the losses because they know the company is undervalued in the market. Fine, but what makes you a fundamental value investor? Because the complexity blows my mind. And I’ve learned to embrace that ignorance… sensing ignorance and danger is wise! While I study the topic a few hours each day, I can’t say I’m an expert. Know what you don’t know!

    You’ve presented a few curiousities, but not a philosophy. You need to learn the difference between technical and fundamental analysis, and between trading and investing. I’m only holding JNJ, a defensive issue, and have earned quite comfortably in recent weeks. I’ve also learned to favor fundamentally exceptional stocks, to wait for the right time to buy, and to accept very small gains, rather than chasing a big hit. Even AAPL is beyond my risk profile. I make about three trades per year, and that’s probably too many! I earn $11/day on CD’s… guaranteed. If I’m switching money from there into a market with risk, there better be a good reason. Vegas is not a good reason. There’s a saying in trading: Bulls can make money, and bears can make money, but pigs get slaughtered. Know what you’re doing, or stop doing it.

  14. Hermann Klinke Link to this comment

    Ramit, I don’t know how much you or others on this page know about investing in stocks, but nobody should invest in stocks unless they really know what they are doing. I started a few months ago really getting into it and there is soooo much to learn and if you really know the stuff, then there is a lot to gain. You can expect returns of up to 100% a year, if you are really good at it and I don’t mean timing the market. I mean doing your technical and fundamental analysis and having several trading strategies. I recommend reading investopedia.com for free and/or pay and learn it from spreadtradesystems.com. What I love about stocks is that you can make money in any situtation, whether stocks are going down, up or staying the same.

  15. Ramit,

    I’m sure you’ve heard this before, but unless you have a lot of time to research companies, you’re better off in a traditional fund or exchange traded fund.

    A vast majority of the pros who spend their days doing analysis fail to beat the “market”. And the fund managers that everyone hails as being above the rest still only achieve low double-digit returns.

    I feel bad for Hermann who thinks that with enough work he can expect 100% returns. That just isn’t going to happen.

    But good luck with whatever path you choose!

  16. I have lost money as well on very good companies. Recently, Whole Foods Market and Yahoo have been killed in the market for “minor offenses” in terms of bad performances. However, i think if you really believe in the company, stick with it. You will be rewarded down the road.