Last week, in our Reporting season survival guide, we stressed the importance of not overreacting when companies you invest in are hit by bad news. Rather than panicking, we suggested investors should analyse the bad news in a rather more cool and detached way. Of course, that’s much easier said than done.
Psychologically, when a share you own suffers a big fall, what tends to happen is your brain will attempt a sort of mental short-cut. You use your past knowledge and experience to help you work out how to behave in this situation. That seems sensible - but why might it be a mistake?
When faced with bad headlines, most people’s brains will naturally think of a similar experience where things ultimately ended badly. It’s our natural defence mechanism and it has served us well as hunter gatherers over thousands of years. For example you may think:
“Last year a man from the tribe was eaten by a lion. Yesterday another tribesman went missing- it must be for the same reason.”
This way of thinking is much less helpful in the world of investing. Why? That natural pessimism completely overlooks many other businesses that have faced similar problems and actually recovered. The tribesman may return tomorrow- with food! Those stories, however, tend not to generate the headlines that corporate disasters do. So they tend not to stick in our minds.
That’s why it is so useful to have the sort of framework we discussed in Reporting season survival guide. To have a series of questions to ask ourselves before making any rash decisions. It helps us to step back and tune out the ‘noise’ generated by negative headlines in an effort to try to think unemotionally and objectively.
Nothing to worry about
If after your cool, unemotional analysis you decide that the company is still in good health and the bad news is merely ‘noise’ you might want to take advantage of the falling share price and buy more. This is called averaging down. However, if you choose to do this, accept this point with near-certainty: the share price is probably going to fall further still.
It’s best to make that assumption. Be at peace with it. Very few people buy ‘at the bottom’. If you are buying the shares today, you have to believe your rationale for doing so is strong enough that even if the price continues to fall, you would be happy to buy more. Not get scared and throw in the towel.
Being objective in the face of negative news is one of the hardest challenges all investors face. The emotional disappointment we feel affects our ability to deal with the news. However, learning this skill is essential to improving your portfolio returns. Some of the greatest investment gains have come from using bad headlines to buy good businesses at their darkest moments.