This is one of the questions I recently received from one of my subscribers. The right answer, of course, is it depends.

Why do Stock Prices Change?

Before I explain how to figure out what to do, it is important to understand why stock prices rise and fall. Every stock has its own market made up of buyers and sellers. Some investors are looking for long term returns and they are mainly concerned with the strength and future prospects of the business they are buying into. The other class of investors are looking to buy stocks that are rising, hoping to book profit in the short term if the rise continues and sell when the price changes direction.

In the short term, the market is a zero sum game – there is a finite number of buyers and sellers and a finite number of investment dollars in the market. Which means for every penny in profit to some investor, another investor somewhere loses a penny. In the long term though, other factors come into play. Demographic changes, increase in wealth of the nation, inflation, competitive entries and exits, growth and decline of companies, they all change the market dynamics. Essentially, if you are a long term investor, you are more concerned about the fundamental business of the company you are invested in, and how the company continues to execute and grow profitably. You are also worried about the macro economic conditions and how they might influence the prospects of your investments. For a short term investor, these are irrelevant.

Ultimately, in the long run, the stock price is a reflection of the value a company has created in the marketplace with its products and services. In the short run, the stock price is merely a result of the demand and supply curves for the shares and may be out of whack with the company’s real value.

With the stock prices being random in the short term, there is no correct advice for a short term investor. There is a school of investing called technical investing that studies and tries to profit from the short term price and volume movements. However, since in the short term the stock market is a zero sum game, profits and losses are more or less equal. It is very difficult for a technical trader to make consistent profits and sustain it for a long stretch of time. Trading the markets used to be very difficult in the old days with full service brokers, but with proliferation of discount brokerages, like Zecco, Scottrade etc. and fast executions, technical trading is now becoming much more prevalent. This creates greater volatility in the markets. If you are a long term investor, instead of being scared of the volatility, you should embrace it for the opportunities it may bring.

So Should I Buy More or Sell?

Lets assume you are a long term investor and you originally bought the stock when you realized that the stock price is attractive compared to the value the company presents. In this case, look at the following 3 aspects before you decide what you should do with the stock.

  1. Has anything changed with the story? – You know why you bought the stock. If the investment thesis is still intact, there is no reason to sell. In the short term, prices may fall for any number of reasons. For example, if a large shareholder sells their stake (such as a mutual fund), it can cause a short lived decline in the prices. However, keep an eye on the recent developments that may be a reason for the stock price decline. For example, when Netflix announced they will separate their streaming video service from the core DVD rental business, many customers decided to leave. This is a fundamental impact on their future prospects and should be evaluated.
  2. Are you comfortably within the allocation limits? – If you find that the story is still the same, you may want to add more shares in the company. It is however easy to get carried away and overweight your portfolio with one stock. If you have already reached the allocation that you defined for this stock/industry/asset class in your portfolio, there is no reason to deviate from it. Remember, you created your asset allocation to align with your life goals and they have not changed.
  3. Is the stock liquid enough? – If you do have more room in your asset allocation that allows you to add shares, then by all means place an order. Many of the smaller stocks are less liquid and even a 100 share transaction can drop the price in the short term. It does not mean that if you want to buy the stock at this new price, you will be able to. In these cases, make sure that you specify a limit price you are willing to pay. If your purchase order does not fill, do not obsess over it or chase the stock. There are many other opportunities out there.

Personally I believe that a portfolio of well chosen 10-15 stocks in a variety of industries and sectors is a good level of diversification and I only invest a maximum of 10% of my portfolio in any one stock. You may have a different risk profile and diversification needs. Just stay consistent and disciplined.

About the Author: Shailesh Kumar writes about stocks at Value Stock Guide, a popular site devoted to value investing. You can subscribe to his investment newsletter for more investment advice and ideas.