Averaging Down
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.
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