Ajay, a close friend called me the other day for my view on a particular investment. He was specifically asking about an investment he held in his ex-company. The stock price was way below his purchase price, and he believed for some reason that the stock price was expected to go down further. His question was “What should I do?” This is a very common question that people have when an investment they hold is likely to go down (or is already down with no prospect in sight).

I told him that I did not have a view on the stock price or this particular business, but I added that his approach of whether to sell or hold needed an Upgrade.

Ajay was making a decision to sell based on the short-term price movement of the stock.

I asked him the following questions –

1. What are the prospects of this business over the next few years and the long term?
2. Is this a sound business? What are the competitive advantages of this business?
3. Does this business have a great team? Can the management of this company be trusted?

There were several additional questions that I asked him, but I won’t list all of them here.

The point I was making is that he had invested in a business and not a stock. A stock is simply a vehicle to invest in a business or to own a business. The short-term stock price movement has nothing to do with the long-term fundamentals of the business. Many times, the short-term price has nothing to do with the short-term fundamentals of a business too. In short, I told Ajay, “You are an owner of a company through its stock. The company you own is a sum and multiplication of many things. The stock you own however seems to be all about price.”

Many investors often confuse price with the quality and long-term potential of the investment. The same logic applies to an equity mutual fund too which is nothing but a diversified portfolio of stocks. The price of an investment in the short term is simply not correlated to the long-term potential of the investment. While you can debate whether something is expensive, fairly priced or cheap, it’s just one data point and truly does not mean much. The price simply measures the current votes and the psychology of the participants in the market.

However, in the long-term, fundamentals are the only thing that matters.

In the short term, there will always be bullish and bearish reasons (all focused on price). We all know the bearish reasons – inflation, tightening of monetary policy by the federal reserve (interest rates will go up), geopolitical risks, yield curve inversion (this will be another post in itself) and so on. There are many gloom doom gurus who will even scream on top of their throats about an impending correction or crash. And after 10 unsuccessful years of crying wolf, who knows they might get it right for 6 -12 months or they could get it wrong yet again. The fact is no one knows.

The bullish reasons on the other hand are many too –

1. Global equity fund flows remain strong.
2. Earnings expectations are pretty strong. Last month, we witnessed the highest GST collection ever.
3. Yields in other asset classes are low and thus selling equities does not seem like an option.
4. Domestic Investors investing in record numbers -Equity mutual funds attracted a net sum of Rs.28,463 Crore ($3.8 billion) in March 2022 and the overall SIP book rose to Rs.12,328 Crore per month.

Coming back to Ajay’s question, there is another simple trick called The Overnight Test that will help Ajay make a decision.

This is how it works.

Imagine you go to bed and overnight, someone presses the sell button and voila your stock is sold. There is no reason to feel anything yet because the next morning you have a choice.

You can either buy the stock back again at the same price or you take that cash and add it to your well-designed portfolio. What would you do?

Till date, no one has ever told me that they would buy back that stock. Neither did Ajay.