Sometimes, I scoop up what I think are cheap shares, only to watch them fall further. And fall. And fall…
My holding in British American Tobacco is an example. At least I am getting paid dividends while the shares lose value however. My holding in S4 Capital has been in steady decline and does not even earn me any passive income along the way.
When a share that already seems attractively priced, what might it mean? How could I respond as an investor trying to balance risk with possible reward?
Why, why, why?
Rather than react emotionally to a plummeting share price (which can feel like a natural reaction), I try to behave rationally.
What does that mean in practice? Basically, my focus is on understanding why some cheap shares I own are continuing to lose value.
Is it because of some fundamental concern about the business, such as declining profit margins? Or could it be more about sentiment, for example because a profitable sector has fallen out of favour with investors?
Both fundamentals and sentiment can be important.
I might dismiss sentiment as wrong, but that does not reduce its impact. I could tie up money in cheap shares for years, or even decades, waiting for wider investor sentiment to match my own. It might never happen.
That said, if investor sentiment about a share changes that does not necessarily concern me. Sentiment can be fickle. On the other hand, if a company’s fundamental business performance is getting worse over time, I always review the investment case. I try to understand why a share has fallen – and what its commercial prospects look like.
Pride can be expensive
Making that sort of rational assessment can be difficult. Having liked an investment case so much to buy, the share makes it easy to have what behavioural psychologists call a confirmation bias. For example, a shareholder may pay too much attention to a company’s strengths while making excuses for poor performance.
But a lack of objectivity can be very expensive.
Making a move
Let us say I can be objective though. How should I to react to cheap shares that just keep falling?I think the answer depends on how I feel about the investment case.
If I continue to think it is attractive, a falling share price can actually offer me an opportunity to increase my holding in a company at a cheaper share than I would have had to pay before.
One risk to avoid is ending up with a single company representing too large a proportion of my overall portfolio. No matter how attractive I think a share may be, diversification is a key risk-management principle.
But what if I think a cheap share could well keep falling in price, giving me a growing paper loss?
In such a situation, it can be emotionally uncomfortable to sell and turn a paper loss into an actual one. But emotions can be an investor’s enemy not just his friend.
Sometimes, what seem like cheap shares are value traps – and the rational move can be to get rid of them, rather than just keep living in groundless hope.
