I’ve talked about the opportunities that falling knives (aka large stock price drops) can create for value investors here. But I had no empirical basis for such statements. I was only making the case that buying a company at a dramatically lower price makes for smarter investing than paying the previous price; in other words, I was ignoring the price action itself. But it turns out the price action appears to be beneficial when it comes to falling knives!
Thanks to the site csinvesting, I recently came across a paper which analyzed the returns of “falling knives” both in US markets and around the world. The findings are unsurprising: stocks that fall big tend to outperform the market in subsequent periods. Interestingly, falling knives outperformed the market for each of the next three years, with the widest outperformances occurring in years 2 and 3; patience is key!
Despite this and other evidence (including mean regression), most traders and the media will continue quote conventional wisdom in warning you against buying falling knives. This is likely because they are focused on how buying a falling stock makes them feel, rather than employing a rational investing approach which focuses on buying when prices are lower than value.
As such, investors should ignore the conventional wisdom. The data suggests falling knives actually outperform.
