Should investors Average Down?
Averaging down is a strategy whereby investors buy shares in a company and then purchase additional shares if the share price drops. Some investors feel comfortable with this strategy, as it this lowers the average purchase price and also lowers the breakeven point for a stock position.
If all goes well and the stock rebounds, investors may be able to secure higher returns than would have been the case if the investor did not average down. So a declining stock is surely a bargain because it is cheaper than it was a few months ago, or is it?
Do falling prices present buying opportunities?
In The Intelligent Investor, Benjamin Graham insisted that investors should see downturns as a chance to buy stocks at discount prices. It was in this spirit that Walter Schloss, who studied under Benjamin Graham before running his own investment firm, said that ‘we like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down.’ So the legends seem to find value investing and averaging down compatible.
Schloss was not the only guru who tried to take advantage of falling prices. Ex-Fidelity fund manager, Peter Lynch, believes that falling prices present investors with a buying opportunity, so long as the company has good long-term prospects. In One Up on Wall Street, Lynch argues that investors should identify ‘a price drop as an opportunity to load up on bargains from amongst your worst performers’. He added that ‘price drop in a good stock is only a tragedy if you sell at that price and never buy more.’
What are the disadvantages of averaging down?
But averaging down goes against momentum...
The big hope implicit in averaging down is that the stock price will eventually rise - but unfortunately for those taking Schloss’s advice - it’s more likely that in the short term they won’t. Buying shares falling in price is a strategy that goes against the momentum effect - the tendency for prices to continue trending in the same direction for periods of three to twelve months. It may sound bizarre, but rising shares tend to keep rising, while falling shares tend to keep falling.
In this interesting video, Peter Lynch himself admits that he learned this the hard way when investing in a company called Stan Oil Ohio. Lynch recalled that:
“Stan Oil Ohio fell from $90 to $60, and I told everybody that this stock is not going to go any lower. Then it went to $50 and I said ‘This is it, no lower’. As it went through $40 I said, ‘This is it’. Finally when it dipped down under $30 and people said, ‘What do I think of Ohio?’, I said ‘What does Ohio do? I don’t own that company.’ I absolutely backed away from it.”
Also remember that it is easier to go downhill than it is to climb back up. If a company trading at £100 drops by 30% (to £70) it would then need to appreciate by over 40% to get back to £100. Bill O’Neil - author of How to Make Money in Stocks- summed it up by saying that ‘the longer you wait, the more the maths works against you’.
Can investors distinguish between a temporary issue or a serious problem?
A falling share price may reflect high bankruptcy risk, broken business models or other problems. Indeed, investors who purchase falling shares could be buying into a value trap (a stock that masquerades as a value opportunity but in reality is a dying company). The company’s sector could be in long-term decline, or technological progress may be radically reshaping an industry to the disadvantage of the firm you invested in (e.g. think of the impact of the Internet on both newspapers and retailers).
Investors should therefore ponder the question posed by Martin Zweig, author of Winning on Wall Street: ‘If it’s such a great stock, why did it drop in the first place?’. We are not advising that investors should sell as soon as share prices fluctuate slightly downwards. However, investors need to do their own research if they are thinking of buying more shares in the same company.
Some of the world's most astute investors, including Warren Buffett, have successfully used the averaging down strategy over the years. But remember that you are not Warren Buffett. Many retail investors may not have the time or expertise to determine whether a drop in price is temporary or a reflection of a serious problem. In fact, if there is a heavy volume of selling against a company, the likelihood is that mutual funds and institutional investors are amongst the sellers. Analysts at these firms are regarded as some of the market’s best informed judges of shares. Would you want to buy when they are selling?
A garden full of weeds
Warren Buffett argued that good investors 'don't garden by digging up the flowers and watering the weeds.' In other words, they do not sells shares which go up and buy the ones which go down. If investors kept doing this, they would have a garden on weeds. Indeed, when investors buy more shares in a company, that company will constitute a larger proportion of the investor’s portfolio. Therefore, by averaging down and purchasing more stocks, investors could end up with a portfolio that is dominated by value traps or companies with poor share price momentum. As Bill O’Neil put it, averaging down can ‘weigh your portfolio down with a few big losers’.
Conclusions
Averaging down therefore poses several problems. Investors would be swimming against powerful market forces like momentum. Furthermore, retail investors may not have the time or expertise to ascertain whether a falling price reflects a serious problem or a temporary issue. It also goes against the maxim of ‘watering the flowers and cutting the weeds.’
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11 comments
Given its recent topicality, worth noting that Sprue Aegis (LON:SPRP) closed today at 150p up 23% from its closing low of about 122p last week. Strong stock rankings (SR89, V96, Q94, M29, G83), net cash position and Magic Formula rank of 98.3 suggest it might be a good candidate to average down on although this requires taking a view on whether the battery warranty issues will undermine the company's market leading position going forward.
I have had mixed experience with averaging down, it depends on the shares, some I would never do it, smaller risky companies I tend to sell if they are falling. But some others have done very well by averaging down, such as Solid State (LON:SOLI), Trakm8 Holdings (LON:TRAK), Staffline (LON:STAF), but Xaar (LON:XAR) is one that did not work so well but it has recovered quite a bit recently. I may sell the original stake when its back in profit, so then just holding the lower priced shares. It is risky, I'm tending now to sell and then if they fall more then buy again which is Robbie Burns strategy.
I'm very happy to average down. But it is always within limits. And I always recalculate. Recalculation may lead to selling or just watching.
The limits are set when I first buy. I decide my position size - initial, ideal and maximum. And my step size - I won't buy again if they haven't fallen enough. My way of managing risk.
I find it works well, but I have a very long time horizon and have no difficulty with discipline or nerve. I don't think I've ever lost by doing it. I have lost by not buying even lower when I've reached my ideal or maximum size. And might have lost by not jumping into my maximum position at the start (if the price has gone up). Not sure it's a good idea for traders because it is an indication that the first buy was wrong.
Hi ratioinvestor,
You've certainly taken your time thinking about it!
Scm
This topic always comes up for debate and it is because there is no general answer. It depends simply on the maths.
- If you generally get say 80% of stock picks right and the ones you get wrong aren't disasters then it can make sense to average down. This rule can be applied to the individual stock in that if it is high quality and has say a 90% chance of coming back then averaging down makes sense.
- if your success rate is say 50% then the risks of averaging down, more capital in a single position in the portfolio, don't make sense.
Generic answers on averaging down don't really make sense. It can depend on the success rate of an investor and the particular stock.
On an unrelated point Buffett generally averages down as he has a high success rate and typically goes for quality companies. It therefore makes sense for him. However, many other investors copy Buffett but have a lower success rate and go for lower quality companies and so averaging down doesn't play out well for them.
Tricky one this - every situation is different.
Sometimes averaging down can work brilliantly - pretty much all of my largest profits over the last 15 years have been from companies where I doggedly stuck to my analysis & continued buying more & more as they fell lower & lower. When the selling overhang was finished, and sentiment changed, I had some serious multibaggers on my hands - a 30-bagger originally with Indigovision (LON:IND) where everyone thought I was nuts buying 8% of the company in 2004, but it paid off with a profit of about £ 5m! Trouble is, I didn't sell, as I'd fallen in love with the stock by then, and then lost most of that money on the way back down in 2007-8.
However, there have also been situations where I've averaged down and it's been a disaster.
So what differentiates the right times to average down, and the wrong times? In my view it's all down to financial strength. So these days I filter out companies with weak Balance Sheets. So by only investing in companies which have a sound Balance Sheet, with little or no debt, then when something goes wrong the company has breathing space to fix its problems.
If a company has too much debt, and then runs into problems, it can be game over. Another commenter above mentioned Luminar going bust. I was in that stock, but as soon as the profit warning came out, I sold on the opening bell - because sales were something like 19% down, so combined with its weak Balance Sheet, there was no way it was going to survive. So proper checking of the financial strength of that company should have stopped anyone from averaging down.
The other thing is that if you do average down, you have to be prepared to wait - a deeply out of fashion stock can take a long time to recover - maybe 6 months, sometimes considerably longer, especially in a bear market. So if you're not temperamentally disposed to waiting for a recovery, then ditching them and walking away is probably a better bet. Personally I don't mind waiting (say) a year for a fundamentally sound company to recover - I think that is the case with Spaceandpeople (LON:SAL) at the moment for example - the stock is deeply unfashionable, as the company has really messed up this year, with 2 profit warnings. However, it's still profitable & dividend paying, and has a sound Bal Sheet, so I've averaged down, and will now wait a year for it to recover.
Diversification is the other thing. If you have lots of stocks, then some will always disappoint, and providing they are financially sound, then waiting for a recovery, and maybe averaging down is usually the right thing to do.
I need to be sure there isn't something fundamentally broken with a company before I average down though. Game Group was a near-miss for me a couple of years ago. I averaged down when the Bank renewed their overdraft, but it went bust just a few weeks later when the suppliers refused to send in stock. Luckily, I picked up on that in the press, and knew it was time to bail out, which I did just days before it went under.
The key thing then is financial strength. Averaging down on strong companies that are having temporary difficulties will usually work, if you're patient. Averaging down on financially weak companies can sometimes pay off amazingly well (e.g. Thomas Cook), but more usually will be a disaster.
Currently reading an enjoyable book; The Zurich Axioms; The rules of risk and reward used by generations of Swiss bankers by Max Gunther.
I do not agree 100% with everything in it but I reckon there are quite a lot of ideas, that if followed might make me a better investor. Axiom number III; When the ship starts to sink, don't pray. Jump! In other words don't add to a losing position, swallow your pride, get out and move on.
Axiom number II. Always take your profit too soon..... and do not succumb to the fear that you might miss out...... and never check the price of a stock you've sold. Difficult to do but protects you from the painful ailment of the "left-behind blues"!
"Losers Average Losers" There is a famous picture of Paul Tudor Jones (one of the all time hedge fund stars) with this on his office wall.
My belief is that if you are a trader (short term holder) this is a great maxim. Do not buy more of anything that has gone against you. In fact cut your loses and let your winners run, is the most powerful maxim in investing and trading IMO.
However, like all rules there are times when the longer term investor can buy bargains in the market when sentiment and short term selling drive prices well below fair value. In this case the investor needs to do detailed research into a company and assess its long term prospects (this is the fundamental thesis of value investing). What I would say is that even with the best research you may not get the full picture. So you must accept your share of failures. However, it is not the %age of wins that make you successful it is the magnitude of your loses versus your wins that makes ALL the difference. And time is frequently the friend of the long term investor.
The key is to identify a temporary blip in trading and the knee jerk reaction of short term investors versus the longer term sea change in a business or industry. Easy to say, but not easy to do.
Oh that's brilliant - I have to share it then... Paul Tudor Jones at his finest...
From my experience, averaging down works for FTSE100/250 companies with steady dividends like SSE, RDSB, NG, BATS and the likes, but not for small caps which can much more easily get wiped out.
I also think averaging down is not a good idea if there is a serious concern, like TESCO, or a high level of short interest.
I used to average down until a few years ago. Back then I was into deep value stocks rather than defensive value, and so I owned Luminar, a leading nightclub company. It went down, so I bought some more. Then it went down, so I bought more. Then it went down, down and down to zero.
Lesson learned.
Since then I've stuck to a plan of making one decision to buy per company, and one only. Then I'll hold for however many years and then I make one sell decision.
It's simple, requires less effort, is less stressful, reduces trading costs and helps me focus on the long-term rather than worrying about which shares are going up or down.