The Worst Mistake that a Trader Can Make: Average Down
Posted by Frugal on August 23rd, 2006
If I’m forced to select only one thing about stock trading to tell you, this is it: do NOT average down. This is not to say that averaging your cost basis on the way down never works. But more often than not, averaging down is a bad decision on top of a wrong one already.
Most novice investors buy individual stocks like buying any other merchandises. When it’s on sale, they buy even more. When the individual stocks are cheaper, they got to be a better deal. It seems to be a good common sense, except that stocks are not merchandises. Stocks are business ownerships. When you buy stocks, you must be in the mentality of investing in good business, instead of buying cheap merchandises. So when a stock goes down in value, it usually means that the business is expected to go downhill. Unless you can convince yourself that market may have the right opinion in the short term but definitely not in the long term, otherwise you should not be averaging down, and keep buying a stock that is going downhill.
You are so convinced about your own opinions about a stock that you are not looking hard enough for any counter-arguments. Or you are simply not thinking objectively. Never be in love with your stock. Stocks come and go, and they are just an instrument to allow you preserve and grow your wealth. They are not you. They don’t need to be in the part of your money. They are just a tool. Do not be so in love with your stock, such that you keep averaging down.
Beginning investors think that if they don’t sell, they don’t incur the loss. WRONG! Always mark your portfolio to the market prices. Do not live in your own virtual reality. A loss that is not booked yet is still a loss. With a trade that has gone bad, you don’t correct that mistake by lowering your cost basis through averaging down. Understand your mistake. Making the same mistake over and over is the cardinal sin of stock trading. Supposed that the mistake is that you bought the wrong stock (or at the wrong time). Now if you keep making the same mistake over and over, do you think it is more likely to get better or get worse? It is better to admit your mistake and move on. When you average down, essentially you have not admitted your mistake. Instead, you bet your money again in attempt to tell Mr.Market “Here is the punch in your face. I’m going to show you that I’m more right than you.” But I got to tell you that Mr.Market is just the market. Market price is what it is. It does not care whether you are right or wrong. There is only one price, and it’s the current price. And either you are losing money or gaining money due to the current price.
No, you don’t get even with Mr.Market. The more emotional you are, the less successful trading you will be doing. You can make the loss up by looking elsewhere. Do not stick out your head for the same falling knife (stock).
When you average down a stock, most of the time, you are buying more than you initially intended to. Your portfolio composition starts to skew towards this concentrated position. One of my work colleague averaged down in a stock for about 4 years. Finally after 4 years, he was out of red losses. In his portfolio, he had pretty much just 1 stock. I don’t mean that averaging-down will never work. But for such scenario, you need to have A LOT of money to keep averaging down your cost basis, and the company must NOT go bankrupt. Taking such undue risk is simply unwise. My colleague had A LOT of money certainly, and he was lucky that the company just almost but did not go bankrupt. Such betting is close to gambling for a 50% of Even/Odd with 2X payout. If you have an infinite amount of money, you will never lose. You just need to bet $1, $2, $4, $8, $16, $32, $64,…. at an exponential increase in bets. Eventually, you can always win and get back all of your previous lost money.
So under what scenarios averaging down can make good trading sense:
- Averaging-down was planned ahead: A planned averaging-down means that the very first move into the stock was not the full intended allocation for the particular stock. Rather because of the great uncertainty in the market, you have chosen to take small steps at a time, and time-diversified your entries into this particular stock. Once a full allocation is reached, you do NOT keep averaging your basis. You take a full stand, and that’s it.
- Averaging-down after thorough technical and fundamental analysis: Assuming that your later decision of buying the same stock stands on its own, and was independent and unaffected emotionally by your previous mistake, then supposedly buying this particular stock this time is as good as any other times. You have done your due diligence. And you are simply acting according to your logical and objective analysis.
- Averaging-down not for individual stocks, but for the general markets: investing in the genral market indexes is better than individual stocks in the sense that individual companies can go bankrupt, while market indexes in all likelihood will not go bankrupt. Averaging your cost basis for your investment in market indexes is okay, as long as your investment horizon is very long term. Having a very long term view on your investment can bring more calm to your mind, away from the day-to-day swing. You are in the market for the long haul, and you are averaging down only because it makes sense.
Personally, I seldom average down for my trades. When my trades don’t go as I expected, I either hold or fold. If I’m wrong, I’m wrong. I don’t want to make the same mistake again. If I’m right, eventually market will agree with me, and make my trade back to a winning trade. I don’t want to average my way down for all of the above reasons. Majority of my averaging down is because it was in the plan.
A conservative investor should FOLD. Only aggressive investor double down to average. An investor with longer horizon can hold, with extra vigilance.
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August 23rd, 2006 at 1:49 pm
I cringed when I read the first 4 or 5 paragraphs of your post, but felt much better when I read that you do agree there are certain scenarios when buying additional shares, not “averaging down”, can make good trading sense.
Averaging down (educated guessing)is not a viable method to attempt to resurrect a stock that happens to be in the downward portion of its NORMAL trading pattern- buying calculated amounts of additional shares based on an awareness of mathematical relationships is. It is, in fact, the essence of the word “trading”.
A very, very small number of investors actually know exactly how to trade. Most people, brokers absolutely included, simply pull a number out of the air and call themselves “traders”. Guessing is nearly always going to be a formula for disaster.
When certain governing rules are in effect, such as (as you mentioned):
a cap on the the amount that will be committed to a particular stock,
stock vehicle selection being determined by participating with reputable stocks in no realistic danger of going bankrupt,
a longer term participation attitude…
buying low and selling high nearly always make sense.
The key is to always be mindful of the the mathematical implications of how numbers actually work and thus be able to know exactly how many shares to trade, if any, in every new situation.
To find this out, so that you can operate (or recommend to others)an investing program based on mathematical law rather than by reliance on so-called “conventional wisdoms” (everybody swallows them because they don’t realize alternatives exist), outright guesswork or prayer, go to
www.howtotradeyourstocks.com
and its linked site
www.crestinvestingsolutions.com -
Use the demo calculator (there’s no learning curve required)and spend a few minutes to contemplate how this changes everything.
Keep up the good work- I know your heart is in the right place.
Rick
August 23rd, 2006 at 3:26 pm
Rick,
Thanks for your thoughtful comment & useful pointers.
I am speaking from my own experiences and from what I’ve seen. Too many people try to average down all way in the 2000-2002 bear market in the high-tech stocks. Stocks like CSCO, you could buy it $80, and then $60, and then $40, and then $30, etc. Each time you would be simply losing more money (the more you buy, the more you lose), while keep skewing your portfolio to be more heavily weighted in a single stock. And there were so many tech stocks like that.
I suggest that one should simply get allocated and be done with it. If you have picked the right stock, time will prove you right. If not, better look elsewhere (and different sectors too).
August 23rd, 2006 at 4:11 pm
Rick,
I checked out both of your links, and the demo calculator. I did not find it very useful. Again, the very first assumption for doing averaging is that eventually the stock comes back. But that’s simply not true. You can easily have your money all tied up, and then 5 or 10 years may pass during a big bear market, and you still won’t see a dime of profit.
As I said in my other posts, anyone who claims a consistent trading profit of more than 30% is most likely not true. A 30% compounded for 20 years give you a factor about 200 (190 to be exact). Now if you just started $50K, 20 years later you can have $10 millions. With such terrific black magic, you (and combining any subscribers) won’t be starting with $50K, but instead $50 million, and 20 years later, you can have $10 trillion dollars, pretty much buy up the half of the USA or any major country.
Since I’m sure no one will own that much money, I’m even more certain that 30% annual return is unachievable and bogus.
It’s true that very few traders can be successful. But even among all good traders, no one can grow the money exponetially on an unlimited basis.
Maybe there is one, Warren Buffet, but after 65 years of investing, he has just some $50 billions. Granted that he started small, but that still doesn’t mean that Berkshire Hathaways can devour the entire Earth after another 20 years to reach $10 quadrillions.
August 23rd, 2006 at 9:57 pm
Do you think the same can be applied to Mutual Funds? I’m just starting out and had recently bought my first mutual fund (International), and was thinking of adding more while the market is down. Of course, i’m thinking long-term and do not plan on selling in 10+ years. That makes it ok right?
And as for the average down, I would think it’s ok if it’s ok to buy when the market is low if it’s from a mega corporation such as Microsoft right? I mean, they will most likely not go out of business, and with time the price will only go back up. What do you think about this? Is it entirely wrong?
(I’ve just gotten into the Personal Finance field a month ago, so there is much to learn. Thanks in advance. Your site is great!!!
August 23rd, 2006 at 10:58 pm
Wins,
There is some difference between trading and investing. When you choose mutual fund, the only criterion above that still applies is that you do NOT want to be too heavily weighted in a certain type of mutual funds. You should always invest with an asset allocation in mind. Once you reach your allocation, you MUST stop. I believe asset allocation is the best practice from my experiences and from what I have studied.
I will write more about investing. But I often write on different subjects besides investing to draw a wider audience to my site. By that pace, there are MANY important things that I want to write about, and yet haven’t reached them yet. For new investors, I recommend reading the following three books (I haven’t finished all of them due to my lack of time, but I’m pretty certain on their quality): two books that I recommend in My Advice in Preserving Your Wealth in 30s to 50s. And one more is The Intelligent Asset Allocator by the same author of Four Pillar. More specifically, these 3 books deal with 3 most important investing concepts: Efficient Market Hypothesis (Four Pillars), Efficient Frontier (Intelligent Asset Allocator), and Economic Cycle (Active Asset Allocation). For traders, there should be one more book on technical analysis. There is a very good book by the same author of Active Asset Allocation for technical analysis. If you’re interested in investing for the long term, you should definitely read all those books. I will have a page for the best books that I recommend. But I’m still too busy to reach that point. And I never want to recommend anything that I don’t finish reading it. So it will take a long time before you see that page from me. But you can get a head-start, if you finish those books before I do.
August 23rd, 2006 at 11:06 pm
Wins,
One more thing. Understanding the theories is still very far from actual practices. You may not be able to apply things from the book after reading. But at least, you can get all of your basics right.
I’ve learned and found my ways by trials and errors through investing for 10 years, to know the importance of those 4 important theories/topics. You can save 10 years of errors and start on the right steps.
August 25th, 2006 at 6:36 am
Would you be so kind as to elaborate a bit on the books you advise. I am having difficulty finding them on Amazon.com. I’m sorry to raise such a concern, but I am very interesting in self-learning in this bizarre science.
August 25th, 2006 at 7:46 am
I just published my book list. You can find all the Amazon links there. I haven’t had time to explain all those theories in any posts. Those special posts require lots of time. But they are the most important theories in my opinions.
August 28th, 2006 at 6:51 am
Carnival of Investing…
Here is this week’s Carnival of Investing, bare and unadorned. I haven’t been able to commit the time needed to do what I wanted to do with this Carnival coordinating thing, so it is in the process of being transitioned to Fat Pitch Financ…
August 22nd, 2007 at 1:47 pm
Great advice, I have not had to much success on averaging down so far. Since I learned the technical part of stocks, I have done much better.