What Happens When a Company's Share Price Drops Sharply?

The three great constants are death, taxes and the stock market will fluctuate.

The three great constants are death, taxes and the stock market will fluctuate.

Owning stocks is like having your own little slice of the American dream. Stock ownership means you own a part of the company and are entitled to participate in that company's financial results. Over the long haul, stocks have proved to be a good investment, typically producing returns that outpace inflation. But individual stocks are not the same as the stock market as a whole. Sometimes stocks don't go up. Sometimes, even when the stock market as a whole goes up, the stock you own might go down sharply. What you should do about it depends on why you bought the stock in the first place.

Why Stock Prices Fluctuate

The price of stocks rises and falls for a variety of reasons, some of which might have little or nothing to do with particular stock you own. Short-term stock prices tend to fluctuate based on positive or negative news about the economy as a whole, impending political shifts, rumors about shortages or gluts of goods, war news and natural disasters. Individual stock prices might also react to such news in the short term, but the long-term price of individual stocks tends to track with the company's earnings, according to CNN Money.

Investment Temperament

Your temperament likely affects all of your life decisions, including your investment decisions, according to the Journal of Investment Counseling. The Keirsey sorter identifies four categories of temperaments: Guardians, Artisans, Idealists and Rationals, based in part on how much risk the individual is willing to take. According to the Keirsey sorter, Guardians are less likely to be comfortable with high levels of risk than Rationals. Regardless of how you categorize your comfort level with risk, it is important to know your level of risk-aversion, because a sharp drop in the price of your stock can trigger an emotional response that might result in an unwise reaction if you don't already have a plan in place to deal with such an event.

Investment Objective

Stock prices rise and fall as a matter of course. An appropriate response to stock price movements, even sharp declines in stock price, should depend more on your investment objective than your investment temperament. Your investment objective might be long-term growth, short-term capital gain, current income, tax sheltering or a combination of these and other objectives. If you bought stock as a long-term investment, and you are convinced the company's fundamentals are sound, a sharp decline in price means little. It might even mean it's a good time to buy additional shares, since the price is so much lower. Since long-term stock prices tend to track earnings, the stock price will likely rebound to reflect its earnings. On the other hand, if you bought the stock on a day-trade hunch that the price would rise sharply, and it declined sharply instead, you simply lost the bet. It's probably time to sell your stock and take your loss.

Make a Plan

Watching the price of your stock plummet can be a gut-wrenching experience. It is vitally important for your financial health to have a plan in place that takes into account both your investment temperament and our investment objective before you start investing in stock. A plan helps take the guesswork out of your decision-making process. Set limits on how much of a loss you are willing to take, and consider placing a stop-loss order with your broker at that level at the same time when you purchase your stock. If the stock price drops sharply, the stop-loss order will keep you from absorbing an even greater loss.

About the Author

Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.

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