Buying crashing shares today at cheap prices may not necessarily produce high returns in the short run. There are a number of ongoing risks, such as a challenging economic outlook and the coronavirus pandemic. They, and other threats, could lead to a further market crash over the coming months.
However, over the long run, the stock market’s growth potential could make now the right time to purchase a diverse range of shares. They could benefit from a likely return to a sustained economic boom and improving investor sentiment that lifts valuations across a wide range of sectors.
Risks facing crashing shares in the short run
Crashing shares may already be cheap after their falls in 2020. They may trade at prices that are substantially below their historic averages. However, if investor sentiment weakens in response to challenging economic data or political uncertainty, it could cause many companies to record falls in their share prices.
Therefore, it is important to accept the potential for paper losses on investments made today over the coming months. The stock market crash from earlier this year showed that predicting market downturns is almost impossible. Therefore, there is always the prospect of share prices falling over a short period should a deteriorating economic outlook cause investor sentiment to decline.
Buying crashing shares could produce high returns over the long run. Value investors such as Warren Buffett have a long track record of purchasing high-quality companies when they trade at low prices. Over time, they have often soared in value as investor sentiment has improved and company valuations have more accurately reflected their financial prospects. With many companies appearing to fall into this category at the present time, there seem to be opportunities to capitalise on low valuations in a wide range of sectors.
The stock market’s past performance shows that a recovery and sustained bull market is likely to take place following short-term volatility. Of course, this can take a matter of months, or even years. Therefore, it is important for investors to manage their expectations when purchasing shares that have fallen in value. Yes, a recovery may be likely should the company in question have a solid financial position and a wide economic moat. But it can take some time for it to happen.
It is also important to manage risks when buying crashing shares. For example, owning a diverse range of stocks within a portfolio can reduce an investor’s reliance on a small number of companies or sectors. It can also mean smoother returns should one industry be less affected by a specific risk or threat compared to others.
Furthermore, identifying high-quality businesses that have fallen heavily in price could be a logical strategy. It may enable an investor to buy those stocks that are not only cheap, but that also offer the best value for money on a long-term basis. Over time, they could be among the least risky opportunities. They may also deliver the highest returns within an index over the coming years.
Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.