I think we have all tried at least once in our investing careers to catch the dreaded falling knife. For anyone who is unware a falling knife is a term used for a company whose share price drops significantly over a short period of time. It can occur when a company announces a downgrade in earnings or market sentiment turns against a particular company or sector.

If you are able to catch the knife at the bottom of its fall then huge profits can be made whereas if you misjudge your entry then these are the times you would much rather forget.

Be it when you are buying a car or even buying your weekly groceries the thought of getting something cheap is a very powerful motivator. As investors we need to distinguish between what is a bargain and what is truly a falling knife.

Here are my rules on deciding when to catch a falling knife.

NEVER buy on an earnings downgrade.

I have lost count of how many times I have watched investors rush in to buy a company whose price has crashed after releasing disappointing results. The impulse to buy is often driven by the belief that the price couldn’t possibly go lower or surely the company is value at this price. In general this first day rush results in a small bounce in the share price which is followed by a long slow decline over time. The main problem with this approach is that as sure as night follows day, one downgrade is normally followed by another. For me, the only exception to not buying on a downgrade is when the downgrade is due to a one off incident or purely an asset write down. The underlying business must still be performing as it was prior to the announcement.

Example: The share price of Shine Corporate Ltd (ASX: SHJ) fell over 70% on an asset write down (work in progress), but its underlying business which had slowed still remained intact. Investors who recognised this and bought on the announcement would be sitting on 100% plus gains.

NEVER buy simply because a share price looks cheap

Investors at times are like clothes shoppers, they tend to rush in when a company is marked down in price especially when they see others lining up to buy. At these times you need to understand why the price is cheap, is it simply a one off or is it a permanent problem?

Example: The share price of Slater & Gordon Limited (ASX: SGH) crashed because a major acquisition in the UK was performing significantly worse than expected. Investors who jumped in on the first announcement believing Slater & Gordon was “cheap” at $3.50 were quick to wish they had never heard of the company.

DO NOT avoid a company simply because its sector is out of favour 

Recent government reviews into the health and childcare sectors saw large share price falls across the board. In all my years investing, I have never heard anyone say the market has “under-reacted” to proposed government changes so these “scares” provide excellent opportunities to buy profitable companies.

Example: The share price of G8 Education Ltd (ASX:GEM) fell close to 50% on concerns of government cut backs in childcare, while the company itself continued to grow strongly. After the market worries subsided, GEM’s share price has gone on to rise over 40% from its lows.

DO believe in yourself

So you have researched the company, it is doing well and the only reason it has fallen is market sentiment. Then why is it so hard to press the buy button? Contrarian investing is never easy, after all we are herd animals and we want to fit in. While investing differently can be hard it gives your returns a chance of standing out from the crowd.

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Motley Fool contributor Alan Edmunds owns shares of G8 Education Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.