‘Don’t Try To Catch a Falling Knife’ Is Advice That Can Help You Avoid Bad Investments
Written by
John Csiszar
Edited by
Gary Dudak
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An age-old Wall Street axiom that you may have heard and not fully understood is, “Don’t try to catch a falling knife.” In the kitchen, trying to catch a falling knife could easily lead to cuts on your hands or fingers, which is why most people simply let them drop to the floor. The analogy with the market is that if you try to buy certain types of stocks, you may slice up your portfolio value.
So, what types of stocks are the ones to avoid, and why are people tempted to buy them in the first place? Read on to learn more.
What Types of Stocks Are ‘Falling Knives’?
The term “falling knives” refers to stocks that are dropping in value and that will likely continue to do so, even if they seem tempting to buy.
They receive this moniker because they can cause real damage to a long-term investment plan if an investor continues to pour money into them, hoping for their recovery.
Real-Life Examples of Bad ‘Falling Knife’ Scenarios
Although it seems obvious that you should avoid “falling knives,” in many cases, they seem to make attractive investments on the surface. If you peel away the layers, though, you’ll see why these types of stocks are actually ones you want to avoid. Here are a few key examples.
Stocks With Too-High Dividends
Dividends are an important component of the total return of the S&P 500. In fact, according to S&P Global, dividends have contributed nearly one-third of the S&P 500’s return since 1926. For this reason, many investors hunt stocks with high dividends. However, companies with extraordinarily high dividends — tempting as they may be to invest in — are typically risky bets.
Stocks with dividends above 6% or 7% — and especially those yielding 10% or more — aren’t giving more money back to investors as an act of charity. Rather, those high yields typically come about due to rapidly falling stock prices.
If a company is paying a yield of 4% and its stock price gets cut in half, for example, it will at least temporarily be yielding 8%. But a sharply falling stock price is usually indicative of problems at the underlying company. Eventually, companies like this tend to cut their dividends, as their diminished cash flow can’t usually support such a high payout. This is the primary reason why stocks with ultra-high or suddenly high dividends are often considered “falling knives.”
Value Traps
Over time, the stock market tends to appreciate in value. While there may be multi-year periods in which stocks don’t go up much at all, over time, the trend is up.
Yet, there are lots of individual stocks that may seem “cheap” but that simply don’t keep up with the market over long periods of time. Usually, these are stocks with low price-to-earnings ratios that seem to be good values due to low expectations for their future performance
Oftentimes, however, low P/E stocks remain that way for a number of reasons, from the cyclicality or unpredictability of their earnings to a history of disappointing investors. This makes these types of stocks “value traps” because they trap investors in the belief that they will eventually make a recovery, when that recovery is far away if it ever happens at all.
Ford Motor Company, for example, has proven to be a classic value trap for investors in recent decades. While trading with a very low P/E of 7.91, the stock still trades at the same price it was at in 1998 — more than 25 years ago!
Doubling Up on Falling Stocks
An all-too-common investment mistake is buying stocks because they have fallen a lot in value. After all, if a stock recently hit an all-time high of $100 per share and it is now trading at $30, it seems destined to return to that high price, doesn’t it?
The truth can be hard to hear. Just because a stock has hit a price at some point in the past is no guarantee that it will reach those lofty levels again. Many investors have wreaked havoc on their portfolios trying to chase these types of “falling knives” by doubling up their investment as a stock continues to go down, down, down.
While it’s true that the market as a whole has always gone on to make new highs after selling off, there are plenty of stocks that will never see their all-time high again. Never, ever buy a stock simply because “it is down so much.”
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