- The advice "never to catch a falling knife" warns investors not to buy a stock when its price is plunging.
- The thinking here is that it is difficult to predict if and when the descent will end and the stock will start to rise again.
- This means that investors who bet on such stocks run a comparatively high of risk losing out – unless sound analysis picks out those stocks that can perform a U-turn.
Market wisdom check
Imagine a falling knife. What would you advise people to do? Most probably, you’d tell them to let the knife fall to the ground first, and then carefully pick it up without cutting themselves.
It is not possible to say unequivocally when a falling stock has reached its bottom, i.e. when its price could start to climb again.
Large stock price drops are not always followed by steep rises
"Never catch a falling knife" is a well-known stock market adage that refers to a stock whose price is plummeting. If you grab the knife – i.e. buy the stock – you risk cutting yourself, meaning you risk losing out financially.
The trick is to know where the floor is. When a knife falls in the kitchen, it is obvious. On the stock market, it is harder. Nobody can be 100 percent sure when a stock has reached its bottom – its temporary low – and could start to climb again. But this is the essential insight if investors in falling stocks are to profit from their calculations.
It is difficult, then, to find the right moment to strike. For stocks often do not immediately go up again after falling – and may fall even further after a pause. Sometimes the problems at companies whose stocks are in freefall are more persistent than expected. If a stock-market slide began because a company was not innovating, it may take a long time for the company to regain its former strength – if it ever does.
There are plenty of examples. The well-known US Internet company that was once considered to be a search engine pioneer. Or the mobile phone provider that missed the opportunity to enter the smartphone business. Sometimes political decisions can also mean that market values remain below previous levels. Just think of the move to renewable energy, for example, which has plunged more than one traditional energy supplier into stock-market difficulties. Because these energy stocks had for many years been viewed as comparatively defensive and as a good source of dividends to boot, many investors simply could not conceive that they would not just recover their losses.
Stock-market favourites tempt us to reach for falling knives
This is a familiar dilemma for fund professionals. With stock-market favourites in particular, investors often expect stocks to return to their old price levels sooner or later. To make matters worse, there often are sharp counter-movements after a downwards slide. For many investors, this reinforces their view that a trend reversal has begun. "However, unfortunately, such swings are often just a breather ahead of more losses," warns Klaus Kaldemorgen, one of Germany's most experienced fund managers.
Of course, there are companies that do manage to turn the tide. So-called turnaround stocks, typically crash on the stock market and then make a brilliant return. Clearly, it is these stocks that create a general tendency for some investors to grasp blindly at falling knives time and time again.
Investors should never buy a stock simply because the price has fallen sharply.
"Basically, a falling price should never be the sole argument for buying a stock," says Kaldemorgen. Anyone who still wants to risk cutting themselves in the hope of a reward should at least identify why the price is falling.
When a stock falls, there are of course reasons. For example, a stock’s price can plunge if the company must report falling profits or is rocked by a scandal. Instead of grasping blindly at falling knives, investors should first analyse carefully what the prospects are of the company posting profits again soon. Or, when can it put the scandal behind it and turn long-term sentiment back to positive?
Investing in "fallen angels" paid off after the dotcom bubble burst around the year 2000, according to Kaldemorgen: "Those who waited patiently for the dust to settle and then made a clean distinction between fundamentally poor companies and mere victims of bad sentiment were able to make a fortune. The principle that 'quality prevails' applies.” Not every falling knife on the stock market leaves investors licking wounds in the long term. But if you have not done thorough analysis, the risk of getting cut is high.