Why You're Crazy to Sell When Shares Prices Fall

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We all know, or should know, that when you include publicly listed shares in your investment portfolio, the daily price movements can be quite a rollercoaster at times. However, few investors understand why, when share prices fall, it really is the worst time to sell. 

We’re going to give you a little maths lesson, but urge you to stay the course. Understanding this lesson could add years to the longevity of your money in retirement by helping you control your emotions at critical times.

All financial assets like bonds and shares are valued on a discounted cash flow basis.  This means future cash flows are estimated (as best can be) and then discounted to a present value (today’s value) based on what return an investor requires to buy a particular asset given its risk profile.

Here is an example of Company ABC.  Table 1 shows the estimated cashflows this company will earn over the next 5 years plus a calculation for cashflows for years 6 and beyond (called a terminal value).  We’ll assume that investors require a return of 10% per annum to invest in a company like ABC.  Doing the maths[i], the equity value of ABC today is $1,015,010, and once we divide this by an assumed 1 million shares on issue, we calculate the current value of one share as $1.02.

Table 1

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Now let’s assume there is a downturn in the economy, which has a negative impact on the market’s expectations for the future cashflows of the business.  If all cashflows are projected to fall by 5%, then Table 2 shows the share price could be expected to fall from $1.02 to $0.96.

 Table 2

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But what also (likely) occurs at this time is the market collectively re-evaluates the probability that ABC can achieve these future cashflows given a more uncertain economy.  The market deems that the risk of investing in ABC has increased.  So whilst previously investors were happy to receive a 10% per annum return for investing in Company ABC, they now require 15% per annum given the increased risk/uncertainty of future outcomes.

So if we retain the 5% reduction of expected cashflows in Table 2, but also now increase the Investor Annual Required Return from 10% to 15%, this has a much bigger impact on the share price as it falls further to $0.83. 

Table 3

Table 3.png

 

Thanks for the maths lesson.  What does it all mean?

The combination of a fall in ABC’s expected future cashflows and a re-evaluation of the risk of the company has seen the share price fall from $1.02 to $0.83 – a 19% fall.  Should an investor sell?  Prima facie the answer is no because:

  • When prices fall, the expected return goes up. The required return of holding shares in Company ABC has now increased from 10% per annum to 15% per annum.  So rather than asking ‘should I sell my shares?’, the conversation should really be ‘should I buy more?’

  • As the economy improves over time, the projected cashflows will likely recover (assuming no company mismanagement – which is always a risk and why we always say an equity portfolio must be well diversified); and

  • We know investing in shares involves risk.  If a share price falls, you have effectively paid for this risk – thus it makes sense to stay in your seat to receive the longer term rewards.

So when a well-diversified equity portfolio falls, the question you should ask is ‘do I buy more?’ rather than ‘should I sell?’ In the December 2018 quarter, the US stock market fell 13.5%. So the expected return of US stocks went up. Although you can’t know for sure when stock prices will rise, in the March 2019 quarter the US stock market was up 13.7%.

It is also important to understand that at any point in time, it’s very hard to estimate what the Investor Annual Required Return is for a particular stock, let alone a diversified portfolio. Stockbrokers and analysts can spend lots of time (that their clients pay for) trying to estimate the cashflows of a company. Rarely do they get this right, but even if they do, they can never be certain what required return the market is placing on the company at any point in time. The required return is essentially driven by Behavioural Economics - or how the collective wisdom of market participants values risk at any point in time. There are too many factors impacting this on a daily basis to quantify it. That is why even if an analyst can accurately project a company’s cashflows, they could still be completely wrong with their share price target. So ask yourself - what value is all this analysis really providing?

Portfolio Rebalancing

It’s worth understanding why we rebalance portfolios and sell parts of your portfolio that have outperformed to buy other asset classes that may have not have performed as strongly.

We noted above that when a company’s share price falls, prima facie the expected return increases. The same applies when a company’s share price rises - the expected return typically falls.

Assume for Company ABC that estimated cashflows remain unchanged as per Table 1, but investors feel comfortable with management and the prospects on the company and deem it is less risky to hold.   As a result, the annual return investors require from this business falls from 10% to 8%.  As shown in Table 4, this causes the share price to increase from $1.02 to $1.11. However the required annual return has fallen by 2%.

Table 4

Table 4.png

So by selling parts of a diversified portfolio that have experienced price increases to buy other assets that have either fallen in value or seen lower price growth, you are actually selling assets with a lower expected return to buy assets with a higher expected return, thus increasing the overall expected return of the portfolio. This is a good thing!

Summary

The decision to buy and sell shares should always be based on your personal financial situation and strategy, and never a reaction to the inevitable daily price movements of stock markets. As the examples in Tables 1 to 4 demonstrate, when prices fall, smart investors should be heeding the phrase “be greedy when others are fearful and be fearful when others are greedy”.

You can read more about investing in shares in this previous article: https://www.stewartpartners.com.au/insights/2018/3/the-journey-of-owning-shares

We thought it prudent to share this article at a time of relative stock market stability – consider it our insurance policy for inevitable future price volatility.  Please be warned that if share prices fall and you contact us to ask whether you should sell some shares, you will be receiving a copy of this article in your inbox.

 

Author: Rick Walker

[1] We assume Company ABC has no debt, the cashflow growth rate in year 6 is 20% and the growth rate into perpetuity is 5%.

Rick Walker