One of the most contentious topics in
investing seems to be the issue of whether you should average up or average
down. That is whether you should consistently add to a winning position or add
to a losing position. Great investors hold strong and often contradictory
stances on this topic and their views are widely quoted. E.g.
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. Walter
Schloss
‘Always sell what shows you a loss and keep what shows you
a profit’. Livermore
...a price drop [is] as an opportunity to
load up on bargains from amongst your worst performers…a price drop in a good
stock is only a tragedy if you sell at that price and never buy more. Peter Lynch
Don’t garden by digging up the flowers and
watering the weeds. Warren Buffet
One of the mistakes investors
can make when reading these quotes is to read these as strict rules. They often
miss the caveats contained within them. For Schloss averaging down has to be in
something still ‘undervalued.’ Lynch says a price drop in ‘a good stock’ is an
opportunity not a price drop per se. Knowing Buffett’s strong focus on the
performance of a business not the market price I’m sure his ‘flowers’ are well
performing businesses with good
economics and his ‘weeds’ are badly performing businesses. I doubt any of these investors are recommending taking
action purely on price action alone yet often we interpret them as such.
The other issue with saying one is ‘averaging
down’ or ‘averaging up’ is it suggests that your current average buy price
matters. It does not. To the fully rational investor a historic trade price is
completely irrelevant. A rational
investors asks themselves ‘given all current information do I have the right
position size in relation to the risks and potential return?’ not ‘should I average
up or average down?’ (See my blog post on portfolio optimisation)
Rules like ‘never average down on a losing
position’ can be used to try to overcome behavioural biases like loss aversion
but they should be recognised for what they are – an attempt to overcome one’s
personal bias – not a general investing rule that everyone should follow. Rules
can be very useful way of addressing behavioural biases (see: my blog post on portfolio rules) But for a rule to be relevant then it must address a bias that has led to past under-performance.
If you have a tendency not to recognise when the fundamental investment case
has significantly deteriorated and have a history of adding to positions that
never bounce back then set a ‘don’t average down’ rule. If you have a habit of
being overconfident and over-sizing your winning positions then set a ‘no averaging
up’ rule.
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