Why some investors risk it all on falling stocks

Some investors, by their very nature, are impulsive. This is to say that you can pour over all the technical analysis you want but, at the end of the day, sometimes your gut wins out over your brain.

As a result, when most of us see a stock has taken a tumble, we get a nagging feeling that we should sell it and stop the bleeding.

One time when I was flying back to the States following a trip to Hong Kong, I found myself chatting about finance with my seatmate. Among the many investment theories he touted to me was “doubling down” on a stock that may have fallen by buying even more of it. As he put it to me, “If it was a good buy at $50, it’s an even better buy at $40.”

So is he right? In truth, sometimes, but there are a couple of questions you’ll need to explore before subscribing to this philosophy:

Why is the stock falling?

This is the first and most obvious question, but it’s also not always that easy to answer. Stocks can fall for a number of reasons ranging from overall market conditions to a specific piece of bad news related to the company. In some cases it may even be a combination of factors that’s driving the price down, making it even harder to say for sure what the cause is. Despite these challenges, it’s worth taking a critical look at the stock in an effort to determine if it still has long-term potential.

Has the company fundamentally changed?

If the stock is falling due to bad news, just how bad was the news? Basically, was it a misstep or a major change that will alter the company’s future? This is what will ultimately decide whether doubling down is doable or not.

Of course what constitutes a “fundamental change” in a company is also subjective. For some, an outgoing CEO is no big deal while for others that leader could have been a major reason for the company’s success. Additionally, while some businesses can buck the trends of their industry, the majority will be affected by negative industry trends.

Before you buy the stock, do your research and determine what it was about the company that made you want to invest. (Source)

In a post for Motley Fool exploring a similar topic, Emil Lee proposed a great sports metaphor for this situation, saying, “If you bet on a football game, and then find out the star quarterback is out with the flu, then the odds have shifted against you. If, however, you find out the third-string kicker is out with the flu, then the odds probably haven’t changed at all.”

Hopefully, before you bought the stock you did your research and determined what it was about the company that made you want to invest. If those reasons are still valid and you’re convinced this downward trend is temporary, then taking advantage of a pullback can be a great investment. That said you should still be careful about placing all of your eggs in one basket.

Conclusion

Buying a stock that you’ve already lost money on may sound counterintuitive — if not downright nutty — to some. However, when you consider the actual logic behind such a move instead of trusting your knee-jerk reaction you may find that there may be a real opportunity in this strategy. As always, just use caution and keep in mind there is a possibility you will be wrong.

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DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.