Lessons from the Trenches
I usually use the Lessons to present trading activity, issues that strike me during the week. Typically things that I see and hear from the traders on my desk spur my interest. It comes from the clients I work with and from other market participants with whom I am in contact all day long. The topic today is averaging into a stock moving away from you, to the downside.
Regardless of your time frame, investment strategy or principal, investors often make the unwise decision of averaging down on particular issues. The scenario is as follows: Client buys 1000 ABCD and later, because of a decline in the stock, the client then decides to buy another 1000 ABCD. The clients' rationale is that if the stock was good at the first price, heck, it must be good at the latter. This often proves deadly.
Averaging down can, at times, provide significant results. As any person that bought in large quantities, right to its' lows, a well-recovered issue. If an investor buys a $30 stock at 30, 20, 10 and 8, and then the issue recovers to 50, in retrospect, it was a great move.
Unfortunately, in my experience more times than not, doubling, tripling or quadrupling down can be exceptionally costly. Momentum typically carries. Stocks in downtrends typically continue. And while many stocks do recover, most do not. Scour the boards and you will find once high fliers in the single digits. Many may never recover. Given today's' high valuations, some issues, having fallen off their perches may never recover yet still be consider overvalued.
Some investors justify the position by becomes analysts. All of a sudden, a stock which was bought for momentum or because it might have a bounce, is being discussed relative to earnings, strong balance sheets, quality management, product lines. The trader becomes the investor. Or the investor becomes the trader. When that metamorphosis takes place, be careful.
The worst mistake I hear is when clients say, "Look, don't you think it's a bit overdone. It's gotta come back. Heck, I can't afford to lose that many points on this. Buy another 2000, it'll bring my cost average down". I cringe. The stock stinks. Its moving down, its selling off, everyone is selling, and you're buying. There is nothing wrong with giving it a shot, bottom fishing, but set limits.
The market doesn't know you. It doesn't care about you. It will take your money laughing right in your face. It doesn't realize that you just made the imprudent decision of putting 60% of your net assets in some 4 letter thing. The market will turn positive in your issue, just enough to raise a glimmer of hope, enough of a catalyst to make the undisciplined trader buy another 2000, just in time, to fade again, sucking the investor into even darker water.
Yet, averaging down is not entirely imprudent. There are strategies in which we might recommend averaging down. I would rather call it averaging, yet in retrospect, it might be to the downside. At times, for clients managed accounts or in discussions with clients, we become interested in a position. Prudence says you will never pick a low or a top, so we average into it.
We decide what percentage of the portfolio we would like to allocate to the stock. We then buy 30% of the position in one transaction. We wait. We wait and see how the stock performs. If it moves higher in line with expectations, we would accumulate a subsequent 40% stake. Then, if the stock has fully met our model, we will complete our position.
If after the initial 30%, the stock has moved lower, we work hard to try and understand the reasons for the downturn. If due to fundamental shifts in business, we stop there. We don't try throwing good money after bad. We own it. If it moves higher, we participate. Not to the same extent, but we perform. If it moves lower, we have powder to work with.
In the end, with clients who I see imprudently averaging down, I often suggest that average into something else. Don't buy the same stock. A dollar is a dollar is a dollar whether its made on GE, GP, BP, LP or NP. Yet in averaging across different stocks, you hedge the risk that that first stock is just a plain loser. Never put too much in any one position where you could get hurt.
Prudence might be boring and at times, you will miss those turn around stories which go from 30 to 8 and then back to 80, but prudence will keep you in the game. Prudence will keep you from losing sleep at night. It is called prudence for a reason. |
