Catching a falling knife can work

AvivaNever try to catch a falling knife, they say, and with good reason. If you get your timing wrong, you can end up with blood spattered all over your portfolio.

And you almost certainly will get your timing wrong. Falling knives are usually plunging for a good reason. The company may have issued a profit warning, its sector may be in freefall or perhaps it has been pecked by a black swan.

The chances are that, after you've snatched at that falling knife, it will carry on falling. If you give it another go, its flashing blade could carve off another slice of your wealth. This is a dangerous game to play.

But you can't stop yourself, can you?

Cuts like a knife

I certainly can't. I've snatched at more falling knives than a circus juggler, and my portfolio has the scars to prove it. I made a clumsy grab for BP (LSE: BP) in May 2010, a couple of weeks into the Deepwater Horizon oil disaster, when it was trading at £5.84. Within days, the shares had fallen more than 40% to £3.28.

I bought Royal Bank of Scotland (LSE: RBS) in May 2010 at 50p, which seemed a great price for a share that was trading at nearly £7 a couple of years earlier.

Just because a share has fallen 14-fold doesn't make it good value. It halved again. Ouch.

I had three attempts at catching Aviva (LSE: AV) in 2010, and boy, did they sting. Whoever says you should never catch a falling knife, well, they have a point.

To be blunt...

But only up to a point. Because if you're convinced in the long-term quality of a company or sector, falling knives are a great opportunity to buy a stake at a lower price.

Even if that knife does keep falling, a good company should eventually recover (although the bad ones won't). Each intervention you make is moving you ever closer to finally making a profit.

In the long run, averaging down can work quite nicely. That's what I'm finding now.

If at first you don't succeed...

I was too fast into BP -- but I learned, and I waited. I didn't catch the bottom (you never do) but, as the price started creeping up, I bought in August 2010 and again in September, at around £4.30.

With BP now trading at £5.04, both interventions are nicely profitable. Better still, they have more than offset my losses from that first, rash trade.

I waited 18 months to top up my stake in RBS, what I thought was an unmissable price of 22p. It has since risen more than 25% to 28p, again, mitigating my early mistake.

I'm already back into profit with Aviva, and that's before you include a string healthy dividend payouts that I've banked.

Oil crisis averted

On Friday, I made good my losses on another falling knife, the Junior Oils Trust, which invests in smaller oil companies such as Dragon Oil, Caza, Soco International and Norse Energy.

I don't often buy unit trusts, especially ones with a pricey 1.75% annual management fee, but I'm not brave enough to invest directly in small oil companies.

Last June, I spotted it had fallen 20%, so I bought a stake at £2.44. It fell another 25%. But I still believed in the sector, and bought more units in August at £2.02. Then again in November at £1.85. And finally, last week, at £2.07.

At the time of writing, it trades at £2.20.

Three out of four trades have been profitable, which is a respectable ratio. And with oil nearing $124 a barrel, Iran tensions growing and China easing its monetary policy, I expect to make that four.

The knife also rises

You have to choose your falling knife carefully. And steel yourself for a bit of pain. But if you're happy to hang on for the long term, those early wounds should heal.

You don't often get a chance to make amends for your mistakes. but I have this time. Thanks to the recent bull market, all my falling knives are flying upwards again.

Life at the sharp end

If a falling knife has caught your eye, be patient. Watch it carefully. There is a good chance it has further to fall. It is getting cheaper all the time.

Profit warnings have a habit of coming in threes. Don't buy on the first piece of bad news. Or even the second. The worst is still to come. Then you might consider buying.

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