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.