When panic selling sets in, the clear-headed investor who keeps their eye firmly on the fundamentals of a company can potentially make a lot of money.
Investing dangerously can make you rich
There's an old investment saying: never try to catch a falling knife. Yet many successful investors routinely ignore it. Why? Because a falling knife can make you rich.
A falling knife is a share that is plunging sharply in value. Think banking stocks in the autumn of 2008 following the collapse of Lehman Brothers. Or it might be a plunging index, sector or commodity.
As the share flashes down, it looks more and more tempting because you can buy at a much lower price than just a few days before.
If it subsequently recovers, you will applaud yourself for your courage and timing. If it keeps falling, you could end up with blood spattered all over your portfolio. So when should you reach for that knife?
A stock may fall sharply for any number of reasons. The company may just have issued a profit warning, lost out to a competitor, been hit by regulatory change, or suffered an unforeseeable "Black Swan" event, such as the Deepwater Horizon oil spill that almost drowned BP.
Maybe the company had simply been unlucky. Perhaps management made a strategic mistake. Or it may have been the innocent victim of a wider market sell-off.
Whatever the reason, you can suddenly buy those shares a lot cheaper than before the bad news hit the wires. The danger is that it will get cheaper still. What do you do?
Your first step is to work out exactly why the share is plummeting, says Jamal Saab, the head of Middle East and North Africa at Natixis Global Asset Management. "You need to assess every single company individually. Was it a singular event, like Deepwater Horizon, or a systemic problem? Will it affect the company's future market prospects? Is there a regulatory threat? How was the brand affected and will institutional investors shy away? Is the company now a target for acquisition or merger?"
You can make good money by investing in damaged companies that remain fundamentally sound and should eventually recover. Many fund managers consistently pursue this strategy, investing in what they call "value" or "recovery" plays.
But you have to know what you are doing, Mr Saab says. "You must consider every possible risk associated with the stock. If you can do that, you can take advantage of events and maximise your returns over the long term."
At any time, there are plenty of falling knives to choose from. That knife could be an out-of-favour asset (say, Dubai property), a country (think Greece) or an entire region (Europe is down more than 20 per cent over 12 months, if you're tempted).
A good time to catch a falling knife is when the stock market is suffering one of its regular bouts of fear and panic - and there have been plenty to choose from lately.
When the market is at its most irrational, the share prices of good companies are routed along with the bad, says Vic Malik, the Mena head of investment advisory at Barclays Wealth and Investment Management. "As panic selling sets in, the decision to buy or sell a stock becomes disconnected from the company's fundamentals. This is the time when a clear-headed investor who keeps their eye firmly on the fundamentals can potentially make the most money."
During a selling frenzy, the market does a strange thing. It loses all sense of time. All it can see is the short term, how shares perform today. It forgets all about the long term. If you can keep your perspective, that can be a great time to invest, Mr Malik says. "This is when the patient, long-term investor can take advantage. You may have to accept some initial losses, but could make big gains in the long run."
If you're convinced in the long-term quality of a company or sector, falling knives are a great opportunity to buy a stake at a lower price.
Even if that knife does keep falling, a good company should eventually recover (although the bad ones won't).
You might have to make repeated grabs as the share price falls lower and lower, a strategy called "averaging down". Each intervention moves you closer to finally making a profit and recouping your early losses.
The most common mistake when trying to catch a falling knife is to reach out too soon, says Jeremy Batstone-Carr, the head of private client research at Charles Stanley Stockbrokers. "It can take time for a company share price to stop falling. The initial blow is likely to be followed by several aftershocks. In most cases, you should wait until some form of floor has been established, where the stock bumps along at its new, lower valuation for a couple of months. Only then should you seize your opportunity."
When sizing up a falling knife, keep your eye on what really matters. "If the company is still able to generate plenty of cash and is sharing that with investors in the shape of dividends, you may have a great opportunity on your hands. Those dividends will keep you ticking over until the share price finally recovers."
Some falling knives are safer than others, Mr Batstone-Carr says. "Take BP. Its share price took a real hammering following the oil spill, but nobody should have doubted the company had a future. It is a massive global blue chip. It took some months before the oil spill was plugged and the share price stopped falling, but it has since made a steady recovery."
You also have to take a view on the state of the global economy, another notoriously tricky thing to predict. "Markets are massively volatile. They can rally one day and convince people that the bad news is behind us. But all too often, it is only a temporary reprieve before they head downwards again."
Mr Batstone-Carr thinks now is a dangerous time to chase falling knives. "I'm getting a sense of déjà vu at the moment, because 2012 is starting to follow the same pattern as 2011 and 2010. Stock markets began the year well, but they can't sustain it. They are still addicted to quantitative easing [QE] and other forms of central banker liquidity. Whether now is a good time to buy depends on what central bankers do next. If they launch more QE, even weaker companies will see their stocks rise."
It takes courage to buy shares that have fallen heavily, says Patrick Connolly, an investment specialist at AWD Chase de Vere. "Most investors only pluck up the courage to buy when everybody else is doing the same. They become bullish and buy after stocks or funds have already risen and become negative and sell after they've fallen. This means they buy at the top of the market and sell at the bottom, which is a recipe for losing money."
If you are plucky enough to buy when everybody else is selling, you could make money by defying the herd. But you may just as easily get trampled in the rush to offload that stock. "Whatever has driven down a share price, whether irrational market sentiment or fundamental problems with the company, could push that price down even further. You can never fully understand how a company works and what is happening internally, which means you are making a grab in the dark," Mr Connolly says.
You also have to understand the maths. Just because a stock has fallen, say, 90 per cent, that doesn't mean it can't fall another 90 per cent.
Say you spot a stock that recently traded at US$10 (Dh36.70), but has since tumbled to just $1. That's a drop of 90 per cent and it looks too cheap to resist. "But at some point, that stock will have traded at $2, down 80 per cent from its peak. If you bought at that point, you might have thought you were getting a bargain. But it then fell another 50 per cent to $1. And it could always fall another 90 per cent to 10 cents."
If you buy a stock that has fallen heavily, you have to accept that you are taking a big risk. "You could make a huge profit, or a huge loss. This isn't for novice investors. You should only take this kind of chance with a small portion of your portfolio."
Mr Connolly suggests there is a safer and more systematic way to apply this philosophy. "You could take profits from any stocks or funds that have performed well over the last year or so and use the money to buy assets that have performed badly. It's not an exact science, but it means you are selling when prices are high and buying when prices are depressed. It won't always work, but in the long run, it's a lot more sensible than doing the opposite."
If you are tempted by a falling knife, you have to brace yourself for a bit of pain. But if you're happy to hang on for the long term, those early wounds may heal.
It is a tricky game to play, so first ask yourself this question: are you the sharpest knife in the drawer?