After seeing our shares hit in the wake of market volatility, deciding what to do next isn’t easy, not least because it’s hard to admit that we may have made a mistake. Anyone who had invested right before the onset of the financial crisis, or just prior to the UK’s referendum on its membership of the European Union, will have felt the brunt of such market volatility.
But some investors end up following a strategy called ‘averaging down’ when their investment decisions go against them. This involves buying more shares after they fall in price, lowering the average cost of all the shares held and thus the point at which the overall trade breaks even.
Here’s an example of how averaging down works. Imagine you purchase 100 shares in a company for £1 each and the price then halves to 50p. You then buy another 100 shares at 50p. To keep things simple, let’s ignore dealing costs and taxes such as stamp duty.
This means that your total holding is now 200 shares at an overall cost of £150. Your average cost is 75p per share. Now let’s assume that the stock price then rises back to 80p. If you sell out now, you will make a 5p per share overall profit, equal to a gain of 6.7%.
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Obviously, averaging down hasn't done anything to fix the loss on your initial purchase - you’re still down 20% on the first investment. This tactic isn’t a magical way of undoing badly timed decisions. However, you’re gaining 60% on your second purchase and you’re coming out ahead overall.
Given that taking a loss can be a blow to our pride, it’s easy to see why averaging down is a popular strategy. But is it a sensible one? Let’s take a look at the advantages and disadvantages.
Why averaging down can lead you astray
Advocates of averaging down frequently point to advice from famous investors to support their strategy. For example, Benjamin Graham – often described as the father of value investing – argued in his book The Intelligent Investor that investors should view downturns as a chance to buy already cheap stocks at even lower levels. Walter Schloss, who studied under Graham before running his own investment firm, said: “We like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down”.
Former Fidelity fund manager Peter Lynch has said that falling prices offer investors buying chances, provided that a firm has good long-term prospects. In One Up on Wall Street, Lynch argues that investors should see “a price drop as an opportunity to load up on bargains from amongst your worst performers” and that a “price drop in a good stock is only a tragedy if you sell at that price and never buy more”.
This kind of advice makes it sound as if averaging down is an obvious principle of investing. But it’s important to bear in mind that this only works if the stock’s prospects are still sound. And the reality is that there are often good reasons for a share price drop.
A company’s outlook may have changed since your initial investment. The firm or the sector in which it operates could now be in long-term decline. New technology can make a once-vibrant industry obsolete. In addition, overlooked problems, such as mismanagement or fraud, might even be coming to the fore.
It can be very difficult to know whether this is the case, especially since it’s easy to become emotionally attached to your favourite investment ideas. Many investors assume that the market simply doesn’t understand the merits of their investment.
But it’s crucial to try and avoid this mistake and recognise that other investors may be seeing something that you’ve overlooked.
How averaging down can work against you
It’s also important to understand how averaging down can work against you. After all, a stock that halves in price will need to double to regain its original level. You always need to be realistic about what kind of recovery you can expect from a share, rather than assuming it will go back to the price at which you bought it.
In addition, investors who’ve averaged down on a stock are likely to have devoted a disproportionate amount of money to it compared with their other holdings. This could easily unbalance their portfolios.
On top of this, when investors average down on a stock, they’re banking on an eventual recovery in the price. But it’s quite possible that this won’t happen, at least in the short term.
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Buying shares that are falling in price goes against the ‘momentum effect’ – the tendency for stocks to continue trending in the same direction for several months. Ask yourself how you’ll feel if your investment continues to tick lower and lower.
All this means that there are many reasons why averaging down is frequently not a sensible strategy. Instead of staying with your winners and cutting your losers, it encourages you to do the opposite. That doesn’t mean that you should never buy more of a share when it’s fallen in price. But it certainly shouldn’t be automatic. In such situations, ask yourself why you bought the stock in the first place and see if your original motivations still hold up.
Each separate decision to invest in a stock should be treated independently. Large price falls should be a reason to re-examine your initial investment decision. Often the best decision may be to sell out altogether and avoid throwing good money after bad.
Always remember that investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.