A lot of new investors (mainly traders) have joined the share markets recently and it’s great to see that a lot of money has been made. This is great for those who have done well from this downturn, but I just wanted to offer some words of warning to those who are new to the markets.
Investing in a downturn is risky business. Just because a share price has gone down does not make it a bargain, and there’s no guarrantee that the price will go back up. The three biggest risks of investing in weakened companies are:
- Insolvency. This is the least likely of the risks in this list, but if the company becomes insolvent, you will lose all your shares and not get any money back.
- Dilution. This is a very likely scenario for ailing companies. As they navigate through periods of unprofitability, they may not have enough cash in the bank to stave off insolvency. The solution for this would be a Capital Raise (CR), in which the company issues extra shares (either from their treasury [unlikely] or new shares) which dilutes existing shareholders holding in the company. With each CR comes more and more dilution, which reduces the share price (because don’t forget the value of the company is not in the price of it’s shares, but the price of all shares added up together – and more shares means less price per share). To clarify, you may get a bargain buying 10,000 shares at $0.50 a share, but end up having to buy another 10,000 shares at $0.40 to maintain your same percentage holding in the company, with an effective buy price of $0.90. Suddenly your cheap shares aren’t so cheap.
- Slow return to normality. This is also another possible scenario, that although your shares will eventually go back up to normal as the economy recovers back to the position is was, this might take a long time. The problem with this is that the longer it takes, the less effective annual return you’ll get.
Finally, there’s another risk which is confidence. When trading on uncertainty there is the risk of loss, which usually makes this type of investment closer to gambling than investing. It’s easy to fall into a confidence trap and think that you’re a great share trader because you successfully picked the bottom of the market and made a ton of money. This is dangerous because if there wasn’t such a fast short term recovery, you would have not been in the same position and could fall fowl of the above mentioned risks.
In summary, beware of buying the bargains in a bear market – it may seem like easy money, but there is safer (and still large) money to be made during a bull market. So to those out there who are praying for a fall in the stock markets, be careful what you wish for and stay safe out there.