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The Short Answer

What to Do When Your Investment Tanks

The first lesson is don't panic.

The market has taken investors on a wild ride over the past year. While there have been a few bright spots in the short term, this wild ride has mostly been in a downward direction, highlighted by some spectacular individual failures. The collapse of Bear Stearns back in March was one of the biggest, and  Fannie Mae (FNM) and  Freddie Mac (FRE) are now teetering on the edge of a government bailout after falling around 90% this year. Quite a few other stocks are down more than 50% this year.

Among mutual funds, too, there have been some startling drops.  Regions Morgan Keegan Select High Income  has fallen more than 60% this year, virtually unheard of for a bond fund, and  Schwab YieldPlus  is down about 30% despite being in the supposedly safe ultrashort bond category. Many emerging-markets funds, especially those focused on India or China, are down 40% or more for the year.

When an investment takes a major tumble like that, many people's first reaction is to sell. That's an understandable response, and sometimes it's a reasonable one. In other cases, though, a big drop in price is no reason for panic, and may even be a buying opportunity. There's no sure way to tell the difference, but it's possible to get enough clues to make an intelligent decision.

First, let's consider what happens when a stock's price drops precipitously. That generally means the company is facing significant problems that have caused the market to lose faith in it. From an investor's standpoint, the big question is whether these problems are temporary ones that will allow the company (and its stock) to rebound once conditions improve, or whether they're the type that will result in even more losses for investors. The latter can be extreme temporary conditions, such as the "perfect storm" that brought down Bear Stearns, or more systemic problems such as a declining industry and/or an inability to adapt to change.

Nobody knows for sure which stocks will recover and which won't, but the right kind of research can help. Morningstar's stock analysts spend a lot of time conducting such research in order to figure out whether stocks are overvalued or undervalued, and their analyses are a great place to start, with the Morningstar Rating for stocks as a useful tool. For example, of stocks that have fallen more than 50% so far this year, 15 have a Morningstar rating of 1 star as of August 25, meaning that our analysts think they're still overvalued, and thus not good bargains. (Premium subscribers can see the entire list  here.) There are 27 stocks (as of August 25) that have fallen more than 50% this year but have a Morningstar rating of 5 stars, meaning that our analysts think they're significantly undervalued. (Premium subscribers can see that list  here.)

You have to look at each fallen stock on its own terms, but some broader patterns do emerge. Certain industries are inherently more attractive than others in the long term, for systemic reasons that may have little to do with the individual stock. The newspaper industry, for example, is facing severe challenges that have caused newspaper stocks to fall steadily. Four newspaper stocks ( Gannett (GCI),  GateHouse Media ,  Lee Enterprises (LEE), and  McClatchy ) are among the stocks that have fallen more than 50% this year but still have Morningstar ratings of 1 star; this recent article by Matthew Coffina explains why we don't think much of the industry's long-term prospects. Some other beaten-down industries are inherently cyclical and therefore have much better chances of clawing their way out of their current troughs. For example, of the 16 homebuilder stocks with ratings (as of August 25), one has 5 stars, nine have 4 stars, and the rest have 3 stars, suggesting that there are some undervalued stocks there. It's true that the home industry has a lot of short-term problems and isn't likely to return to its heyday, but the business isn't going away, either.

On a stock-specific basis, certain features tend to make a stock more likely to rebound after a big drop in price. Stocks with wide economic moats (strong competitive advantages) are less likely to fall dramatically in the first place, and more likely to look attractive if they do. Among the stocks that have fallen more than 50% this year, 14 of the 15 1-star stocks have no economic moat, whereas the 5-star stocks include one wide-moat firm ( Advisory Board Company ) and nine with narrow moats. For the most part, these are highly profitable and in good competitive positions, but face headwinds that appear to be temporary or based on cyclical factors. For example, Advisory Board gets most of its revenue from the health-care industry, which faces uncertainty over the direction of health-care reform, and  Boyd Gaming (BYD), a narrow moat stock that's down 65% this year, is suffering from a drop in gambling due to the slowing economy. Ultimately, each stock has its own issues that have to be evaluated separately, but some beaten-down stocks are certainly in better shape than others.

When a mutual fund plunges in value, it's also a good idea to do some research before deciding what to do. However, the issues involved are somewhat different. A stock represents a business, and in the above cases we're trying to figure out whether that business will survive in anything like its current form. A mutual fund represents a portfolio of stocks or bonds chosen by a manager, and when a fund falls sharply we're trying to figure out whether that manager is likely to do any better in the future.

The first thing to consider when one of your funds tanks is how it's doing in relative terms. All too often, investors panic when one of their funds suffers losses, without considering that other similar funds may be losing even more. To give one current example,  Matthews Pacific Tiger (MAPTX) has lost 22% for the year to date as of August 25, which looks pretty bad at first glance. But the entire Pacific/Asia ex-Japan stock category has been hammered this year, and this fund has actually been one of the best performers in the group, ranking in the top 10%. Some other funds in the category, such as Dreyfus Premier Emerging Asia , have lost almost twice as much as the Matthews fund this year. In a market like the one we're in now, when macroeconomic factors are causing just about everybody to lose ground, about the best you can do is try to lose as little as possible.

Even if your fund is trailing its peers in the short term, that's not necessarily a reason for concern. Even the best funds go through periods of underperformance, so it's always a good idea to look at a fund's long-term record rather than focusing on short-term results. Ultimately, Morningstar's fund analyst reports are the best way to judge whether a fallen fund is worth hanging onto, because they take into account all the necessary context. Out of the 184 funds that are Morningstar Fund Analyst Picks, meaning they're among our favorite funds in their category, nine are down more than 20% this year. Several of these are among their category's worst performers this year, including  Clipper (CFIMX) and  Schneider Value , but we're still big fans of these funds despite their short-term performance woes. On the other hand, if something major has changed--for example, if the manager responsible for a fund's great long-term record has recently left--you might be more justified in getting out in the face of poor recent performance.

Finally, there's one danger that investors should be aware of when a fund falls quickly in a short time--namely, the possibility that massive redemptions could cause it to spiral further downward. That's what happened to Regions Morgan Keegan Select High Income, which owned a lot of bonds tied to subprime mortgages when the mortgage crisis hit last year. When those bonds fell in value, lots of people jumped ship from the fund, and those redemptions forced manager Jim Kelsoe to sell many holdings in a terrible market for high-yield bonds, thus making the situation worse. Such a "run on the bank" scenario is fairly rare, though, and it's much more likely in areas which don't trade frequently, such as high-yield bonds or emerging-markets stocks or bonds. A large-cap stock fund isn't likely to have such problems, though of course it could have other issues that make it a candidate to sell.


David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.