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Eric Houssels
Eric Houssels
Articles 

The Falling Knife

March 20, 2007

The falling knife really requires no introduction. We’ve all seen them, most of us have owned them, and we all certainly know that we are supposed to wait for them to land and wobble a bit before our first purchase. To this last bit of advice, my simple reply is “easier said than done.” Recent contemplations on the falling knife yielded the following four square:

Keeps falling Stabilizes; bases to grow again

 

Buy

Regret; feel stupid; emotionally want to give up; defiant

Lucky (no doubt) but rewarded for having conviction

Wait

A little smarter but risk paralysis

Never get the position on; can fake the ‘oh well’ attitude (and that is ok) but note, can’t wait forever

A couple of quick notes on the above are necessary. The “keeps falling” or “stabilizes” verticals reflect the post-decision outcome for the stock, while the “buy” or “wait” horizontals reflect the actual decision made in the present. The “lessons” in the box attempt to capture the resultant emotion or psychology given both the decision and the resultant movement in the price of the stock. Finally, I hold the above to concern only those stocks of good businesses, profitable companies and not speculative situations which have a complete life of their own and are outside of the boundaries of the falling knives that more typically tempt my operation.

My incoming “hope” for this four square was to prove that buying falling knives was a wonderfully courageous and appropriate profit-maximizing act but the above table does not really support this. Let’s consider each box in turn:

Buy, Keeps falling: the most intensely emotional; really just want to go hide somewhere. Its real enemy is the “Wait, Stabilizes” box and note that that box does not provide nearly as intense a reaction in my opinion (if you never do anything, you won’t get hurt being the basic premise here).

Wait, Keeps falling: the danger here is the paralysis; you were proven right (on a non-fundamental basis) and why won’t the non-fundamentals keep proving the rightness? At what point, however, do you step in as a fundamentalist and commit to the reasonable course of action for the long-term. I believe that the margin of safety concept, if based on good rational thinking, provides the best answer to this dilemma. If the stock, even as it falls, is underpriced by a legitimate margin of safety (25% at the bare minimum), scrap the fear and act. It is very important to note that this same answer applied to the “Buy, Keep falling” box before the decision was made. While it can be painful to watch our investments go “down” on the screen, the best we can ever do is to a) demand a margin of safety and b) act rationally when it appears.

Buy, Stabilizes: well done and lucky, not useful to discuss any further than this.


Wait, Stabilizes: the aforementioned enemy of “Buy, Keeps falling.” Easy to live with (and it is okay to pass on stocks as errors of omission are much better, in my “do no harm” world than errors of commission). The more hidden problems are that too many of these may spur accumulative remorse which could lead to bad thinking down the road.

The ultimate answer lies, as usual, in simply being rational. Know your thesis and know what you are doing. If it is rational - if Mr. Market is just acting manic - take advantage. But, to be rational, the thinking must not be based on hope (nor must inactivity be based on fear); it must be based on a quiet interpretation of fact. PERIOD.

A couple of final points are worth mention. First, focus focus focus on the big picture thesis, and squelch the noise; don’t “read the mail” if this is what it takes. Second, and a most difficult one for a great number of us, be humble. You may actually be wrong on occasion; it is hard to tell for certain when you have made a mistake. If an investment is on review as a possible mistake, work very hard at being honest with yourself, reassess the situation, and behave rationally once more.

About the author:

Eric Houssels
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 1.8/5 (5 votes)

Comments

wildcat
Wildcat - 10 years ago    Report SPAM
Value trap?
biscosc
Biscosc - 10 years ago    Report SPAM
Brandes wrote a great paper on falling knives in the US and then followed it up with looking at falling knives worldwide. The US paper is not on their website but the international one is, have a look:

http://www.brandes.com/NR/rdonlyres/5E4FE92D-B271-444F-99FD-7DBB96E9368C/0/BI_FallingKnivesAroundtheWorldPaper.pdf
ehoussels
Ehoussels - 10 years ago    Report SPAM
Thanks Biscosc for the link. I found the article to be thorough and informative. Most interesting was the wide difference between the average and the median, indicating that picking the winners is both essential and potentially very rewarding. Cheers.

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