The opposite of Averaging Down is, you guessed it, Averaging Up - the process of buying shares in a company and then buying some more as the price gets higher. Often called ‘pyramiding’, this approach is particularly popular amongst classic momentum investors like Bill O’Neil and Jesse Livermore. Even some of the biggest disciples of value investing have done it. Warren Buffett started buying Berkshire Hathaway when it was $7.60 in 1962. He kept buying even after it had risen to $14.86 in 1965. Averaging Up could raise the average price that investors pay for their stocks and seems to go against the principle of buying low, selling high. So why do investors do it?
What are the advantages of Averaging Up?
1.Managing Risk
In the first instance, investors can limit the average price that they pay for stocks by making smaller and smaller purchases as the price gets higher - such that one’s purchase sizes resemble a pyramid. For example, rather than buying 100 shares at £100 and another 100 at £200 (average £150), they could instead buy the first 100 at £100 and another 50 at £200 (average £133).
If the first trade turns bad, risk can be limited as you’ve not bought a full position size, while you only unfold your full exposure if a stock ‘acts’ well and rises.
2.Investing with momentum
Trends have had a historical tendency to persist in the stock market. This is known as the momentum effect. Research which looked at data between 1945 and 2008 found that a strategy that went long recent winners and short recent losers (i.e. top and bottom 10% of stocks ranked by 1 year price performance) returned an annualised 16.5% with remarkably low volatility.
Momentum investors argue that pyramiding purchases are made on a less risky basis because the first entry is smaller, so investors would have less exposure to a falling stock. Furthermore, later purchases are only made after a stock shows signs of having strong share price momentum. One’s average purchase price is higher, but, according to Livermore et al, the stock is behaving correctly. Momentum investors argue that Averaging Up is less risky than Averaging Down.
