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How Falling Stock Prices Can Make You Rich

Part 2 of 2

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What if the opposite happens? What if investors panic, sell their 401k mutual funds, pull money out of the market, and the price of your bank collapses to, say, 8x earnings? Then, you’re dealing with a $40 stock price. Now, the interesting thing here is that although the investor is sitting on a substantial loss – from $60 per share originally to $40 per share, knocking 33+% off the value of their holdings, in the long run they’ll be better off for two reasons:

  1. The reinvested dividends will buy more stock, increasing the percentage of the company the investor owns. Also, the money for share repurchases will buy more stock, resulting in fewer shares outstanding. In other words, the further the stock price falls, the more ownership the investor can acquire through reinvested dividends and share repurchases.

  2. They can use additional funds from their business, job, salary, wages, or other cash generators to buy more stock. If they are truly concerned with the long-term, the losses along the way in the short-run don’t matter – they’ll just keep buying what they like, provided they have sufficient diversification levels so that if the company were to implode due to a scandal or other event, they wouldn’t be ruined.

There are a few risks that can cause problems:

  • It’s possible that if the company gets too undervalued, a buyer might make a bid for the company and attempt to take it over, sometimes at a price lower than your original purchase price per share. In other words, you were absolutely correct but you got pushed out of the picture by a very large investor.

  • If your personal balance sheet isn’t secure, you might need to come up with money and be forced to sell at massive losses because you don’t have funds anywhere else. This is why you shouldn’t invest in the market any money that could be needed in the next few years.

  • People overestimate their own skills, talent, and temperament. You might not pick a great company because you don’t have the necessary accounting skills or knowledge of an industry to know which firms are attractive relative to their discounted future cash flows. You might think you’re able to watch losses pile up while you purchase stocks, but very few people have the temperament for it. In my own case, it doesn’t even cause my heart rate to elevate if we wake up one morning and before coffee, the office portfolio is down hugely in a matter of minutes. It just doesn’t bother us because what we’re doing is building a collection of long-term cash-generating ownership stakes in firms that we want to hold for a very long time. We’re constantly buying more. We’re constantly reinvesting our dividends. And many of our companies not only reinvest for future growth, but also repurchase their own shares.

Now, this is a gross oversimplification. There are many, many, many details that haven’t been included here that would factor into a decision about whether or not a particular stock or security were appropriate for investment. This is designed to do nothing more than to provide a broad sketch of the outline of how professional investors might think about the market and selecting individual stocks within it.

The bottom line – for a guy running a mutual fund, hedge fund, or a portfolio with a limited amount of capital, big drops in the market can be devastating both to their net worth and their job security. For businessmen and businesswomen who think of buying stocks as acquiring partial ownership in companies, they can be a wonderful opportunity to substantially grow your net worth.

As Buffett said, he doesn’t know if the market will be up, or down, or sideways a month or even a few years from now. But he does know that there will be intelligent things to do in the meantime. Not everything is doom and gloom - the collapsing dollar has been a magnificent thing for multi-national firms such as Coca-Cola, General Electric, Procter & Gamble, Tiffany & Company, et cetera that are able to ship money back from overseas markets into cheaper greenbacks. Just remember – there is a buying and seller for every financial transaction. One of those parties is wrong. Time will tell which one got the better deal.

More Information

This article is part of our How to Get Rich guide for new investors. For more information on how to take control of your finances, generate passive income, control your debt, and become financially independent, read How to Get Rich - A Guide to Getting Rich.

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