It has been a dramatic week in the markets – and there could be a lot more where that came from. Uncertain stock markets can sometimes be a great place to go bargain hunting. That helps explain why I maintain a list of shares to buy if a rocky market pushes their price down to an attractive level.
But in doing so, I try to remember a few important principles.
A big fall in price does not necessarily equal a bargain
When the market tumbles and a share price falls rapidly, it can be tempting to think there must be some value on offer.
In reality, though, just because a share price falls a long way does not necessarily make it a bargain.
Instead of comparing the cost of a share now to what it used to be, I think it makes more sense to compare it to what I think it is worth based on future commercial prospects.
Some shares get knocked down and don’t come back
Back in the dotcom boom of 1999-2000, UK tech retailer and service provider Computacenter soared, then crashed.
It came back to its previous price – but it took two decades to do so!
Other shares get clobbered in a turbulent market and never make it back to their former price.
It can be tempting to think that a rocky market drags most shares down, so when the tide turns most will come back.
In reality that is not necessarily true.
It matters whether the cause of a crash directly affects a business or not – and also whether it has the financial means to ride out a storm.
As I look for shares to buy amid the current market turbulence, then, one question I am asking myself while weighing up the valuation of firms like Nvidia is whether their long-term business value has likely been reduced, or not.
Irrational markets still call for rational thinking
When the market behaves in odd ways, some investors do the same.
Maybe a share price has become so seemingly compelling, for example, that they forget the important risk management principle of diversification and put a disproportionate amount of their money into a single investment.
That can be a costly mistake when the market is calm – and also when it is not.
Take Reckitt (LSE:RKT) as an example.
During the last market crash, following the beginning of the pandemic, an investor might have decided that there was money to be made in hygiene products.
Reckitt has proprietary formulations, strong brands like Lysol, deep experience, and a worldwide distribution network.
Yet, over the past five years, the share price has fallen 16%.
That is bad enough but it is put into even worse perspective when compared to the FTSE 100 index, of which Reckitt is a constituent. The index has moved up 50% during the same period.
Some of the problems Reckitt has faced, like lawsuits related to its nutrition business, were not necessarily obvious five years ago.
But that is exactly the point! Even an excellent company can run into unforeseen problems.
So, no matter how tempting a particular share may seem when choppy markets move its price much lower, a savvy investor always stays suitably diversified.
This post was originally published on Motley Fool
