Averaging Down
(c)1999 TLC
may not be reproduced without permission
I said to myself, “Self, that has got to be the most absurd investment concept I’ve ever heard.”
No, my friends, I’m not talking about the publicly traded company that claimed their research into time travel was a sure -fire thing, because eventually, no matter how long it took, they would succeed, and at that point they would travel back in time and give the solution to the original shareholders. You think I make these things up? People bought shares in that company with right -now money.
I am humbly wont to offer Dr. Stephen Hawking’s argument against the workability of time travel - namely that if it was possible, we would at this very moment be inundated by tourists from the future. Personally, I wouldn’t mind getting a few shares of CSCO on the first day it traded publicly, so let me know if I’m wrong on this.
Yes, my friends, I am talking about “averaging down”. Maybe you remember the first time you heard about it. I do. A broker explained it to me. In truth, it could have been my mother who tried to explain it, or an article in a newspaper, but it happened to be my broker (at the time). “Nobody can ‘time the market’, Mr. Chicken,” he said. “Nobody knows which way the market will go in the short term, but long term, I believe the market will go higher. That’s why it’s smart to average down.”
In the unlikely event that one of my readers doesn’t know what it means, permit me to explain “averaging down”. “Averaging down” means you buy more of something as it goes down in price, thus lowering your overall cost basis. For example, if you buy 100 shares of stock in XYZ at 40, and XYZ then goes to 30, you buy (for example) 100 more shares, and your cost basis is then 35. If XYZ then goes down to 25, you buy more shares, and your basis is then even lower. In this way, (according to the theory) you are assured that when XYZ stops going down and starts going up, you will be on board at a good price.
Does it work? Absolutely! As long as the stock stops going down at some point, and then starts going up, and the patient investor has managed to get his basis low enough, he will be profitable at some point. “So, Chicken Brains,” you ask (and rightly so), “what’s your gripe?”
I have four gripes.
Let’s take a look at the concept of “averaging down” in the real world. First, if you are going to do it, you need mo’ money. You bought 100 shares of XYZ assuming it would increase in value. Unfortunately, you were wrong, and it went down. These things happen, your friends say. You can’t be right all the time. You need to buy more XYZ, so you either cough up part of this month’s paycheck, move some of your cash account into XYZ, or sell some other asset to obtain the cash. You don’t want to sell a stock that is moving up (at least, I don’t), so your only other choice if you want to sell an asset is to sell something that is not moving up. But you can’t do that, because you should be averaging down on that asset, too. You have the cash in your cash account to buy something that “looks good.” This eliminates XYZ, because it is going down, and that is not Looking Good in my high school yearbook.
That leaves this month’s paycheck. That’s what the market calls New Money. The market likes New Money. New Money makes the world go ‘round! New Money is where I run into trouble with “averaging down”. My basic underlying philosophy about investing in the stock market is: Buy Low, (not Buy Lower). You might have a different underlying philosophy. But, having my philosophy, I am reluctant to buy something that is going down in price (with one exception, which I might get into some day) with my New Money. In essence, I’m trying to ‘time the market’.
Nobody can do that? I disagree. I think every mutual fund manager that beat the market average in 1998 did it by ‘timing the market’. He bought low and and/or sold higher than the market average. Did any fund manager that beat the market average do so by “averaging down” with the New Money that came into his fund? We’ll never know, but we do know that most fund managers did have some New Money to play with in 1998.
And that brings me to my second point. I would humbly ask any proponent of “averaging down” what happens if I run out of New Money to average down with? Ask somebody that owned Internet hardware provider WXYZ in January of 1997. Did it end up working out? As of March of 1999, yes it did, providing the investor held onto his stock. Assuming the investor bought the stock at 60, averaged down all through 1997, and didn’t run out of New Money to invest, he might have gotten his cost basis below 40. But, personally, that was a ride I would not have wanted to be on.
I’ll tell you what I did. I heard about WXYZ from a friend in early 1997. I knew little about the Internet, I knew nothing about WXYZ. I did my usual homework, which I suppose could be the subject of another article. Then I did something I’d never done before. Since I didn’t understand what WXYZ did, I asked some people who used their products what they thought of the quality of the products. I got a very favorable response. I called the company and spoke to one of the executives. Then I then made the decision to invest in the company.
Then I waited and waited and waited and waited. I waited until it stopped going down. In December of 1997, I bought the stock. I bought more in January of 1998, at a higher price. I averaged up!
Had I bought the stock in early 1997, and “averaged down”, I would have had a rough year, because I don’t like having my investment be worth less every time I look at my statement. Worse, since the stock went down more than 50%, I might have changed my opinion about the company. I’ve noticed that the performance of the stock can have an influence on my opinion of the company. I don’t think I’m alone in this, and that’s my third gripe about “averaging down”. I would rather have cash in my account than be invested in anything (except maybe my kids) that loses more than 20% of my New Money. An investor has to factor in his “grief quotient” - the amount of mental anguish he is willing to endure when things go the wrong way. My tolerance for mental anguish is extremely limited, primarily due to these ugly scars I have. At some point in the future, perhaps I shall learn something The Easy Way.
Fourth, “averaging down” violates one of my rules - Don’t Buy When You Wish You Were Short. I never shorted it, but to say I wish I were short WXYZ in the spring of 1997 would be an understatement.
As it turns out, I bought my first shares of WXYZ about 2 bucks off the bottom. By the time the stock got back close to where it had been trading in early 1997, when I had first considered buying it, I had doubled my money in less than twelve months. Then the stock went up another 50% from there! I only need about one of these a week, and I’m fine.
Assuming he still owns the stock, and didn’t run out of paychecks, the investor that averaged down on WXYZ starting in early 1997 doubled his money in 2 years, which by normal non -tulip standards is about as good as it can get.
But I whupped him. I saved myself some serious gastro -intestinal distress and got a four-bagger that eventually went to 100 bucks. Counting my losers, I still whupped the market. And I did it My Way. |
