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TLStockPicks (90.55)

Averaging Down

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June 06, 2008 – Comments (5) | RELATED TICKERS: DE

Cramer has brainwashed my brother... so much so that my brother believes "averaging down" is the way to go. 

UGH!

For the uninitiated, averaging down is the process by which one buys, for example, 100 shares of ABC at $50. Then, when it drops to $40, he buys another 100 shares, so that he gets to say his cost basis is $45 instead of $50.  Sounds great, except you now own 200 shares at $45 basis instead of 100 shares at $50 basis, which both equate to $1000 in losses.  (well, actually averaging down also leads to 2x the commissions, lower cost basis for tax treatment on twice the shares, and double the exposure/risk).

So why on earth would one average down?  The usual logic (?) is twofold: 1) the $40 dollar stock only needs to rise by $5 to "break even" and 2) the stock that you thought was good at $50 is now on sale--why not get more?.

Argument 1 is absolutely true.  But what exactly do you get for "breaking even"?  A boost to your ego?  A feeling that you made a good play?  Oh, and what happens when the stock swings $5 the wrong way? Suddenly, you're down $2000.  You're basically leveraging your own position 100% and doubling your bet on an investment with downward momentum that the market just said was wrong.  Sounds like good money after bad.

Then there's argument 2.  You did your due diligence.  You thought $50 was great.  Well, when you redo your valuations and fundamental analysis at $40 and convince yourself that 100 shares at this price are an absolute necessity, I'd hope you don't miss the fact that you ALREADY OWN 100 shares at $40.  That's right, your $50 dollar stock just turned into the $40 dollar stock you're looking to buy.  Doubling the amount you own just threw off your diversification and increased your exposure.  The fact is, the market gave you feedback on your original buy.  It said, "you were wrong."  Being wrong at $50 doesn't mean you're twice as right at a lower amount.  Could the market have been wrong in its feedback?  Maybe.  But who are YOU to think you're outsmarting the market?  Or, as a column on dummyspots.com puts it, "What makes you think you’re a better judge of [the stock] now that you’re bleeding?"

Now my brother has a third argument.  Paraphrased, it's "I'm not so arrogant to think that my first entry price is right... therefore I'll wait for it to drop down to level B, where i'll buy some more, and then to level C, where I'll buy even more."

Well, to realize maximum benefit, he's hoping he's wrong short term, but right long term.  Defies logic?  I think so.  I wouldn't mind if he "averaged in"--that is, if his short term timing was actually good, he'd buy his other shares as the stock goes up just like he would if they went down.  But, nope.  Only if he's wrong short term will he have the # of shares he originally wanted.

Are there occasions when portfolio management calls for averaging down?  I think so.  One example: if you are attempting to keep a certain stock (or industry, sector, global diversification, etc) at a certain % (say, 10%) of your portfolio, and that % has dropped to about 6% of your portfolio because that stocks price has dipped by 40% while everything else stayed the same, then sure, re-up that investment until you are at 10% again.  But the goal there wasn't to take advantage of how wrong you were... it was to maintain your portfolio diversification at certain levels. 

So, I tried.  I pleaded.  My brother still initiated an average-down buy of DE (John Deere).  I like the stock... I'll even make an outperform call on it. But I disagree with his entry method. 

5 Comments – Post Your Own

#1) On June 06, 2008 at 6:49 PM, QualityPicks (22.35) wrote:

Averaging down is a strategy. Depending on many things it can be really good or a disaster. In general, I don't like it, mainly because of the things you've mentioned. But often, once you understand well the strategies, the investment, and the pros and cons, you can use it successfully. I don't like Cramer either, he is really good and really bad at the same time. He does and says many things I consider irresponsible. But what can I say, your brother may have to learn the hard way not to trust hype and TV gurus.

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#2) On June 06, 2008 at 6:52 PM, falcon2382 (29.92) wrote:

I would have to say that averaging down isn't that bad as long as its not literally "averaging down" that you are performing. These kinds of systems based on price alone ARE foolish. However, If you truly believe in a company based on due diligence and serious research than you enter in at a price that you believe gives you--in Buffet and Graham's words--"a margin of safety." If, in the event the price continues to deteriorate, but the underying busines isn't than why not add more to your position? Buffet does that all the time? All that said, my point is merely to differentiate between following the "divining rod" of price halving versus augmenting investment based on sound reasoning and due dilligence.

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#3) On June 06, 2008 at 7:16 PM, TLStockPicks (90.55) wrote:

Agreed, Falcon, though I will add that when one claims to have redone his due diligence at the lower cost and proceeds to buy the same # of shares as he did the first time, while also never doing any dd if/when the stock price rises...  I think there's a smidgeon of literal "averaging down".

It's hard to compare what Buffett does... because he's in a unique situation.  When he buys, he must buy sooooo many shares that if he were to buy them all at once, it would shock the market and he would end up paying a lot more than he needs to due to the temporary supply shortage in that stock at reasonable prices (even with stocks with tremendous liquidity, it would take time for the specialists and other sellers to get those shares onto the market).  Buffett has to buy in phases, and I'm willing to bet that he'll average up as much as he averages down.  Also he is managing a portfolio and when he likes a stock, he's aiming for it to become a certain % of his portfolio rather than looking at some specific price.  Or so I think...

 But as for my poor brother... he basically bought his first batch and told me exactly what his next price triggers are (all downwards), at which point he will buy the same number of shares.  That's about as literal of averaging down as you can get.  And Qualitypicks, unfortunately he probably will never learn his lesson since he'll always have those times when it worked in his favor to console him.

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#4) On June 07, 2008 at 10:33 AM, JoHooch (< 20) wrote:

Funny how people who LOVE averaging down would NEVER buy more of a stock that is appreciating.  Like if you bought a 50 dollar stock and a few days later it was 52 dollars and looking strong, buy more! 

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#5) On June 07, 2008 at 11:20 AM, masterwill (< 20) wrote:

How about averaging down with the same amount of money invested as appose to the same amount of stock. This way your actually taking advantage of the lower price as appose to having a clean cut average between the two prices.

5000$ at 50$/share, 5000$ at 45/share$ and 5000$ at 40$/share. If you originally thought that the stock was a good buy at 50$ a share, then I would rather be at 336 shares a total of 15000$ invested when the stock is at 40$/share then 300 shares at total of $13500 invested. 

Your basically putting your money where your mouth is.  

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