When you're investing in the stock market, it's important to know what all of the Wall Street terminologies mean. One term that you may have heard is "underperform." But what does that mean?
In this article, we'll take a look at the definition of underperforming and what it means for stocks.
What is an underperforming stock?
Two meanings can be derived from underperforming stocks. The first one is underperforming the market while the other is underperforming an analyst's rating. The average market return is about 10% over the long term.
So, if a stock is underperforming in the market, it means that it is returning less than the market. For example, if the stock market is up by 10% and your stock is only up by 5%, then your stock is underperforming the market.
Many people make the mistake of picking individual stocks without sound research and then get disappointed when their stock doesn't perform as well as the market. The second meaning of underperforming stocks is an analyst's ratings.
Analyst ratings are important for stocks, and "underperform" is one of the lowest that a stock can get. If an analyst rates a stock as "underperform," it means that the stock is not expected to perform well in the future.
It could also mean that the stock has underperformed its previous expectations. For example, if an analyst expected the stock to go up by 20% but it only went up by 15%, then the analyst would rate it as "underperform."
Although the stock outperformed the market, it underperformed the analyst's expectations. This is why it's important to not only look at the market when you're picking stocks, but also look at analyst ratings.
To summarize, an underperforming stock is not meeting expectations or living up to its potential. This can be due to several factors, including poor management, a weak industry, or simply bad luck.
While there are risks associated with any type of stock, underperforming stocks can be especially dangerous because they may not have much upside potential. It's showing signs that the underlying company is not doing well.
Underperforming stock example
Mr. Market has been on a tear lately. The Dow Jones Industrial Average is up 15% over the last 12 months. But not every stock has kept pace with the market. In fact, some stocks lost value during that time. For example, shares of XYZ Company are down 20% over the last year.
This means that XYZ Company has underperformed the market by 35% over the last year. In the case of a stock underperforming the market, we can take a look at a fictitious example of Mr. Speculator.
Mr. Speculator is an analyst that is widely known for his stock-picking abilities. He has been able to beat the market by a large margin over his career. His latest analysis of ABC Company led him to believe that it was a great buy.
Mr. Speculator wrote a report about how he believes that it is a 'Buy' at $100 and is expected to go up 1000% over the next ten years. The stock price of ABC Company starts to rise and reaches $120, giving Mr. Speculator a 20% return on his investment in just a few short months. However, the stock then starts to head back down and falls to $90.
However, he is not worried because he has a 10-year time frame. But, after a few more months go by, the stock price continues to fall and Mr. Speculator is now down 50%.
He assures that the stock is still a buy but fast forward to 10 years later and the stock only returns to the value of $100. In this scenario, Mr. Speculator's analysis was wrong and he failed to beat the market.
Analyst ratings and reviews are important, but you shouldn't blindly follow them. You should always do your own research to make sure that you are investing in a good company.
The risks of underperforming stocks
Underperforming stocks can be a cause for concern for investors. If you're thinking of investing in a stock, it's important to be aware of the risks.
Here are some of the most common risks associated with underperforming stocks:
- The company might be in a weak industry
- The stock may not have much upside potential
- Poor management could be a reason for the underperformance
- The stock may be underperforming because financially, the company is not doing well
Don't mix up underperformance with undervalued. Just because a stock's price is lagging behind the rest of the markets, doesn't mean it's a bargain. It could be underperforming for a reason. For example, the company might be in a declining industry or have poor management.
The industry might have had a lot of potential but the company failed to capitalize on it. It could also be because of a company's weak financial position, they were not able to capture the upside opportunities in an emerging market.
Whatever the reason may be, make sure to evaluate the risks before investing in any stock, especially an underperforming one.
When it comes to stocks, there is always risk involved. But, with underperforming stocks, there is often more downside than upside potential. Often when there is a lot of hype in the markets for new hot stock, analysts might be biased to their emotions and give the stock an unfairly high rating. This can lead to investors following their buy signal and ending up with positions in their portfolio that are underperforming.
When it comes to stocks, there are a lot of different factors that you need to consider. You can't just look at the price and make a decision. You need to look at the company's financials, the industry, and the management team.
By taking a comprehensive approach, you can avoid underperforming stocks and put your money into companies that have a bright future.
Do you have any experience with underperforming stocks? Let us know in the comments below.