Why we, the people, should never average down any stock January 23, 2007Posted by deminvest in dictionary for democratic investors, HOKU Scientific, investment, investment strategies, My investing mistakes.
It is such a temptation. We feel so well when we take an “Average down” shot. But it can be lethal for our wallet. Let’s see what it is:
To average down = to buy more shares of a stock which somebody already holds and which has dropped in price since the earlier purchase . When somebody does so the average price paid for each share goes down.
I bought 10 shares of PENTAIR INC (PNR) at $41,16. Now their value is $30.23 so I am losing 27%. If I buy another 20 shares on PNR now, I will have in my portfolio 30 PNR shares bought at an average price of $33.9 and I will be losing “only”12% of the investment. Moreover, if I average down PNR and it goes back up to $40, I will be able to sell it and make a hefty gain. If I don’t average down, at $40 I will still be losing.
From my example, averaging down seems cool… But there is quite a few a big buts.
1) It is addictive, like gambling… I did it several times in the past: Stock went down 30% I figured everybody was selling for wrong reasons so I averaged down… then stock went down another 30%. I was almost pleased… I thought: “Incredible! I can buy such good stock at this ridiculously low price”… If you do that a few times, you have most of your money stuck in a stock that may never recover.
2) There is an investors saying: “Trend is my friend”. It is easier to follow a trend rather than getting into a stock right in the moment in which the trend switches from downward to upward. Averaging down is the best way to follow a downstream trend and lose a bunch of money. The stock goes down and you continue to buy it more and more as it continues to go further down.
3) There is no limit of how much a stock price can go down. Actually there is one limit: 0, as Enron stockholders know.