Why we, the people, should never average down any stock January 23, 2007
Posted by deminvest in dictionary for democratic investors, HOKU Scientific, investment, investment strategies, My investing mistakes.trackback
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.
Example:
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.
Democratic Investments by the people for the people 
Oh, I found the answer to my last question.
My rule is not to hold 1 stock whose value is > 10% of my portfolio. So when I buy, I buy 3% of my portfolio in a stock. If it dips, I can re-buy twice, only putting me at about 9% of my entire portfolio on 1 stock.
Often, however, I only end up holding the first buy when I end up selling, at 33%.
This is a good way to keep under control our averaging down instincts. You solve problem number 1) and 3) that way.
I don’t average down because of problem 2). Usually professional investors put STOPS to get out od a downstream trends. I can’t quit a stock I liked just because it went down 10% like they do. But furter buying on it means going a bit too far.
Also, if I pick the right stock (it may happen 🙂 ) I want to have invested what I had planed when it goes up. If my choice is good, there is no reason to hope it will go down before bouncing back up. If it is good it usually goes straight up.
I try to invest the same amount: $1000 every month, although I often lose control when I see a “supposed bargain” and get more.
Also I try to keep my stratgegy simple. I feel that if I make it too complicated, it will be hard for me to evaluate it and to explain it to others:
BUY —> KEEP UNTIL UP 40% —> SELL IF UP 40%.
I am still not sure about time factor… I think you asked me about it: if a share goes up 40% in 15 years it is not very good. I am working on some ideas about starting to set higher targets after a certain amount of time, but that would be complicated and I fear what is not simple.
Also there is an interesting way of selling on zecco.com: a trailing stop. I is a stop that follows a stock that is going up and sells as soon as it changes direction. It would allow me to avoid things like Hoku that I sold at +40% and was +60% in three hours. If I had put a trailing stop at -3%, it would have followed till up 60% and sold at +57% instead of selling at +40% like I did. It is good because often shares that gain 40% continue going up. If they don’t and they change direction, I get a sale at + 37%, wich is still good enough. I haven’t done it so far mainly for sake of simplicity.
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