I recently read that gambling apps on smartphones try to identify those gamblers who chase their losses, in order to target them with marketing. This icky business practice shows that gambling companies see loss chasers as the most profitable customers. But it also reminds me about why I don’t often ‘average down’ as an investor.
What Is Averaging Down?
Averaging down is when you buy shares in a company below the price where you already bought shares. This brings your average entry price down. To my mind, averaging down is just fancy language for adding to your losers. This article — and my aversion to averaging down — is about when you pay a lot less when buying more of a stock. I am not talking about small drifts within a range. I’m talking about buying more of a stock when you are already down 30%, 40% or even 50%.
Investors who believe they have a superior ability to calculate intrinsic value are the most likely to chase their losses. Sometimes, they truly do have a good valuation ability, while in other instances they are simply deluding themselves. Importantly, I posit that both types of investor would be better off not chasing losses.
Even Professional Investors Shouldn’t Average Down
You see, even assuming you are a smart value fundie with a history of estimating intrinsic value better than most investors, averaging down into notable losers (say, stocks that have already fallen 40%) means you are actually allocating more capital to the subset of investments that you are most likely to be wrong about. Let’s talk facts.
Fact 1: If you bought a stock then it fell 40%, you probably made a mistake valuing it already. Maybe, the market has gone from ‘a bit wrong’ to ‘very very wrong’, but either way you failed to predict that that would happen. A good investor should have an understanding of why a stock might fall, and ideally try not to build a position right before it does. So if you bought before a 40% decline, you probably missed something important in your research.
Fact 2: Generally speaking if you have a better understanding than others about a stock, it is a riper area for making alpha. This is why investors develop a circle of competence.
Fact 3: Allocating capital to where you have a worse understanding than the market, is allocating to your own weaknesses. Allocating to where you have a better understanding is more likely to lead to outperformance.
Why Averaging Down By Adding To Losers Can Minimise Returns
All these facts mean that if you’ve had a big loss on a position, you’re probably better off looking elsewhere. There are exceptions to the rule, but we are creatures of habit. In my view, averaging down (in a meaningful way) is not a good habit to pick up.
In large part, that’s because adding to losers is the main way risk controls fail.
For example, A few years ago funds investing in Freedom Insurance Group (ASX: FIG) kept on buying even as the market was expressing a view that the receivables should not be valued anywhere near book value. By doubling down on the same mistake, some funds built positions that they could effectively never get out of (without tanking the stock). They were stuck and essentially had to ride the thing to zero.
Similarly, a naive retail investor could end up with too much of their portfolio concentrated in a single stock, if they keep buying more to get their average down. It’s all very well to say that you’ll limit a single position to 5% of your portfolio, but if you keep on topping up on the way down, then you could lose much more than 5% over the course of the investment.
What Is A Losing Investment?
Obviously, allowance must be made for normal volatility; a stock falling 20% is sometimes meaningless, but usually a steeper fall of 40% does mean something. I have no hard and fast rule about how to define a position as “a loser”, but the share price is definitely my first consideration. Sometimes, a smaller share price drop accompanied by unexpected bad news might indicate a stock is a loser (for you).
For me, a drop of 50% means I assume that I have made a mistake. I generally would never add in such a situation.
When Investing, Water Your Flowers, Not Your Weeds
Sitting on a loss might not tell you a lot about the business, but it tells you something about how well you’ve forecast the share price. And that is new information worth paying attention to.
Water your flowers, not your weeds.
When you’re starting out, it can be hard to know how to approach investing. I firmly believe that the best investment you can make is in your own knowledge. If you’re considering the Rask Value Investing program (a good starting point for company analysis), then use our discount code a-rich-life, and we’ll receive a contribution, too.
A Rich Life depends on Supporters to pay for its free content, so if you’d like to try Sharesight, please click on this link for a FREE trial. It saves me heaps of time doing my tax and gives me plenty of insights about my returns. If you do decide to upgrade to a premium offering, you’ll get 2 months free and we’ll get a small contribution to help keep the lights on.