The Averaging Down Clown

We have all been there. You do your research and your due diligence.  You check the valuations and the charts. You calculate the risk/reward. You maybe even get all patient and wait for a catalyst. For all sorts of good and clever reasons, you decide to buy 100 shares of company XYZ, paying, let’s say, $50 per share.

A few weeks later, you recheck your portfolio. Company XYZ has fallen to $45. After cursing a bit, you recheck your valuations and research, and conclude that nothing about your original view has changed. In fact, the trade looks like an even better deal, since you can now buy shares for only $45. You pay $45 for another 100 shares.

Time passes, seasons change, you grow a beard and the stock falls to $40. Again, there has been no material news or change in your analysis of value. You decide to buy another 100 shares: after all, if you liked the trade at $50, you must love it at $40! Even better, the stock only has to rally back to $45 for you to break even. If it gets back to your original purchase price, you are in the money!

This logic seems common for professional and amateurs alike. It is psychologically very tempting, not least because it means that you do not really have to admit that you are wrong. It is strongly encouraged by a fundamental analysis/valuation mindset: without new information, trades that go against you simply look like even better opportunities. At the very least, this encourages you to not exit your losing trade, and even to commit more capital.

This is very dangerous.

The reason that it is dangerous is not that it does not work. It does work, quite often. Doubling down pays off, you make even more money than you originally thought, and you feel like a champion. That positive feedback encourages you to do it again next time.

The danger comes from what happens when it does not work. When you keep adding to a trade that keeps going against you, you will eventually lose. Perhaps the fundamental situation changed, and you were not aware of it yet. Perhaps the market simply has a different idea of valuation than you. Perhaps the market is being manipulated. It really does not matter why: at some point you will lose. And by using a strategy of averaging down, you are guaranteeing that your biggest positions will be in your worst trades.

Let that sink in, and I will say it again.

You are guaranteeing that your biggest positions will be in your worst trades.

 Averaging down feels great. It fits in with our popular acclaim for those who “have the courage of their convictions”, who “stick with it when the going is tough”. Unfortunately it also sets you up for a massive fall.

In contrast, a strategy of averaging up into winning trades puts your largest positions in your winning trades. If you pyramid up, your average price rises slower than the market price i.e. you are effectively buying at a discount to the current market. For example, if I buy 100 shares paying $50, 100 paying $55 and 100 paying $60, my average price will be $55: $5 below the market price of $60. Contrast that with the earlier example of averaging down, where my average price was $45, $5 below the market price of $40.

Another way to consider it is to examine the four possible basic outcomes to any trade:

1) Wins initially, and keeps winning.

2) Wins initially, but then reverses to become a loss.

3) Loses initially, and keeps losing.

4) Loses initially, but then reverses to become a win.

If you average down, you only get the chance to add to trade types 2, 3 and 4.

If you average up, you only get the chance to add to trade types 1, 2 and 4.

Averaging down tends to be attractive to people, since it allows the possibility of trade type 4 i.e. a trade that goes against you, but then reverses to recover your losses and more. However, that comes at the material risk of trade type 3 i.e. the trade that never recovers.

Averaging down virtually guarantees that your biggest positions will be in trade type 3 i.e. the trades that never win. Pyramiding up avoids this risk, and also allows you to add to trade type 1 i.e. the trades that start off winning and keep winning.

To be clear, there is a legitimate strategy of picking a range of entry into a trade. Rather than picking a particular price point, you may choose to scale into a position over a range of entries. The distinction here is that you must decide this plan before the first entry is made, rather than in response to a trade going against you.

Averaging down is psychologically easy, and feels good. The market tends not to reward behavior that feels good and easy. It might not punish you straight away, but averaging down losing trades is a great way to end up owning a lot of shares in the next Enron or Lehman Brothers. I prefer my biggest positions to be in my winners.

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12 Comments

  1. Thanks for highlighting the difference between “averaging down” and “scaling in”, the latter being a great way to trade equity-based ETFs with mean reversion based strategies.

    Reply
    • No problem, David. I personally prefer to “scale up” into a position, but can understand why others prefer to “scale down”. Scaling into a position is legitimate, as long as the scale is determined in advance of the initial position being taken. “Doubling down” in response to a trade going against you and other Martingale type strategies serves only those with an appetite for destruction.

      Reply
  2. Matt

     /  August 28, 2012

    What happens when you keep averaging up and then a disastrous quarterly earnings report sends the stock down 20% after-hours before you can sell a share? It’s all about concentration, not whether you should average up or average down. Who says that you need to keep buying all the way down (or up) so that the position is too big?

    Reply
    • Matt, agreed on your concentration point. You absolutely do not need to add to a position at all. Blindly adding to a winning trade is silly: you should always keep in mind if each pyrmaid is a good idea or not, and keep an eye on your overall risk.

      Reply
  3. revelo

     /  August 28, 2012

    Averaging down works fine for value investors. Not so well for momentum traders. Suppose I eat lots of tuna fish. I buy a case for $1/can and then the price drops to $.75/can so I buy several more cases. Then the price drops to $.50/can and now I back up the truck and buy as much as I can. So what if the price drops still further to $.25/can? I don’t have to trade this tuna fish, I can eat it, and I got a great deal. Likewise, if the price drops far enough on a DIVERSIFIED portfolio of QUALITY stocks (upper-case qualifiactions are to ensure bankruptcy is not an issue), then who cares if the prices drops still further after you plunge in 100%. Just hold for the huge dividends and other payouts (quality stocks, by definition, return cash to stockholders in some way).

    In the short run the stock market is a voting machine. In the long run it is a weighing machine. If you are certain you are getting good value for your money, and you have diversified so that freak business events aren’t an issue, then you will eventually do well.

    Reply
    • Thanks for the comment. With respect, I disagree. To continue your analogy, what happens if all that tuna you bought turns out to be rotten? You are left with vast amounts of worthless tuna, and it is likely to be one of your larger positions. And you can’t say “It’s okay, I will just hold quality stocks that will never go bankrupt” because history is rife with examples of companies that appeared to be solid and all of a sudden were not, either due to fraud, mismanagement, geopolitcal events, macroeconomic changes and/or technological disruptions. If you had made a list of “quality/will never go bankrupt stocks” back in 2002, I am pretty sure that that list will include names that would not be on a similar list today.

      Reply
      • revelo

         /  August 30, 2012

        Maybe one name on a list of 20 quality stocks (minimum needed for diversification) compiled in 2002 would have gone bankrupt. So you lose 5% on that stock and make it up on the other 19. That’s the nature of quality stocks: low-debt, wide-moat and sustainable earnings means they are pretty resilient and don’t go bankrupt easily. KO and PG are classic examples of such stocks and I’d be happy to commit 5% of my money to either of these if they became really cheap in a market panic. Don’t trust quality stocks? Then just use SPY. If SP500 drops to 600, I’m be happy to go all in and not because I pre-planned a scaling-in strategy. So what if it continues dropping to 300? The dividend yield at 600 would be too compelling not to commit completely. As for SPY going to zero, yes that could happen, in which case there will be more important things to worry about than money.

        Because the stock market is mostly efficient nowadays, opportunities for buying quality stocks or SPY at a true bargain prices are rare. Prices don’t drop to ridiculous levels in stocks because there is too much money sloshing around in bonds/cash waiting to switch to stocks whenever they become reasonably cheap. In less efficient investment sectors, like real-estate, opportunities for great deals are more frequent. Prices drop to amazing levels, you buy in, then prices drop to even more amazing levels. Fortunes are made by those who continue to buy even as prices continue dropping and everyone else is afraid to buy because they think the world is coming to an end. I’ve seen situations like this many times in my life in real-estate and such situations exist now in real-estate in parts of the country. Those who play it safe, like you are effectively suggesting, never get anywhere.

        But I’m talking about investing. Things are different for momentum traders.

      • revelo, thanks for reading. Scaling in according to a pre-determined plan I can understand. Buying value I can understand. Buying when others are panicking I can understand. What I disagree with is the concept that one should keep buying a falling market at lower and lower prices simply because it looks like a better and better deal and because it validates your initial decision to buy too high. The problem is that sometimes the world does end, especially for individual issues, and you lose a much bigger chunk of your stake than you should. Using your example, you could end up with a lot of tuna that you can’t eat after all. Or the 1 out of 20 of your previously quality stocks goes bankrupt: if you had been averaging down, that stock might be more than the 5% of your portfolio you initially allocated.

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