The real cost of averaging down

“I do not like to lose”. Joseph Schooling who recently won an Olympic gold medal for Singapore mentioned this, possibly several times, during interviews. In fact, nobody likes to lose. Whether we are in school, at work, in games or investing in stocks, we never like the feeling of being a loser. If anyone tells us that he trades stocks to lose money, then I think there is really something wrong with him. He must well take the money and donate to charity and make a name for himself.  The fact that we trade or play (whatever we can call it) stocks, is that we want to win, and of course, the reward for being a winner in stocks is the dollars and cents that come along with it.

So, from a human psychology point of view, we get into stocks because we want to win. It is that simple. Consciously or unconsciously, trying to win in every stock becomes our guiding principle. To keep the subject in focus, I shall leave investing in stocks as a portfolio in another session (or my conducted courses or another forum) and concentrate on our reactions to the individual stock price movements. The fundamental fact about investing is that not everyone is a winner all the time. No matter how robust our selection system and how well-timed our entry points are, there bound to have occasions when we bought a stock and the share price tanked, maybe for several weeks or even months. For some unlucky ones, they could have bought a stock right at a peak price, and never able to see any higher price for the foreseeable future. Now what do we do if we happened to be one of those unlucky ones. A lot of people mentioned about stop loss, cut loss, sell into strength whatever we can call them. But in reality, how many people really are willing to do that? Being human beings, we do not like to lose, and that actually inhibit us from selling stocks at a loss (or even to buy stocks in the first place). It’s very extremely easy to sell at a loss for paper trading with no emotions involved, but to sell at a loss with real money really takes a lot more courage to do so.

Guided by this ‘not-to-lose’ principle, it is not uncommon that people average down in hope of a turn-around in the stock price somewhere in the future. But there is really a cost in averaging down.

Let’s take a hypothetical case. The on-going price is $2 and we make a purchase of 1000 shares. Not including brokerage and all the other charges, the cost to us is $2,000. Let say each time when the stock tanks by 50%, we make purchase to average down our purchase price (see table). By the time when the price became a penny stock of $0.125, we would have made several rounds of purchases, and even that our average price is $0.38, which is 3 times more than the on-going trading price. Of course, this case is one out of infinite possibilities of what can happen in reality, but the point here is that the whole exercise were carried out totally relying on numbers… no emotions, purely mechanical and well-disciplined.  In this example, I am assuming that we purchased more stocks each time the stock price dropped 50%, if one starts to average say at a drop of 20%, then it would be a lot harder to average down.  So in reality, there is a cost in using the ‘averaging down’ technique especially when a turn-around is not in sight.

Perhaps, you may argue that the assumption that the stock price drops from $2 to $0.125 is not realistic. But if one were to be diligent enough to check on the stocks that have dropped 90% from its peak value for the past 5 to 10 years, perhaps we can already find quite a number of them. Furthermore, given the flagging economy, and with a series of bad news affecting some sectors of the economy, it is can be quite common to see some stocks giving up  90% of its peak share price. (Click here for the video clip)

While there are some costs involved for averaging down, there are also some categories of stocks that are worth applying the average down strategy. They may not be sure-win strategies, but they certainly worth at least a consideration.

In summary:

  1. Stocks that are not worth to average down – These stock prices tend to trend downwards. They are companies that are incurring losses, bad cash-flow, high-debts, poor management, consistently difficult business environment or any combinations of them. Averaging down on these stocks is usually quite suicidal unless we are very sure that the fundamentals have changed for the better. Otherwise, there is really no point in averaging down.
  2. Stocks whose share price do not change very much – Frankly speaking, there isn’t much benefit to average down on stocks whose share price does not change over time. The apparent incentive to buy more of these stocks is we are attracted by its dividend payout. Basically we are in accumulative mode and not applying the average down strategy. The REITs and some high yield stocks exhibit this nature.
  3. Stocks that worth to average down – The average down strategy is best applied for stocks that show some degrees of volatility, but appreciate in value over time. The volatility enables us to buy subsequent stocks at lower prices, and hence averaging down the share price. However, over a longer period, it gains in value. Certainly, the average down strategy is best applied to stocks that are classified as blue chips. Of course, this is a sweeping statement as the share price of some blue-chip companies still trade within a tight price range. Frankly, we should be thankful that the SGX had changed the trading board lots from 1000 shares to 100 shares. This will allow more trading liquidity among in retail trades and make the averaging down technique more efficient. Yes, there will be more brokerage cost involved, but it will be more or less cancelled out as we accumulate more stocks at a lower prices.

Happy investing!

Brennen has been investing in the stock market for 26 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy.