Even the mention of averaging down among some investment circles will lead to a very quick and hostile education on their errors in your ways. Averaging down refers to a position entry strategy whereby the investor attempts to acquire more and more shares as the stock price drops. This results in an overall lower cost basis for the position, and allows more shares to be purchased than would have been possible with other methods, assuming a fixed amount of available capital. Those opposed to averaging down argue that you are only throwing money at a losing investment, rather than focusing on investments that are doing well. Which is correct? Let’s look at both sides of the coin.
Cut your losses
Most investors preach a strategy of dumping positions in stock that drops to a predefined stop-loss price regardless of the future potential of the investment. This serves to minimize the maximum amount that can be lost on any particular investment (except for cases of illiquidity or overnight gaps down). The stop-loss is typically fixed at the time of initial entry and is usually a sixed percentage or dollar amount below the entry price. For example, we might set a 10% stop on a stock purchase of $50 per share, resulting in a $45 exit price if things go south. In this way, our maximum loss is $5/share, except for the caveats above.
The flip side of this method is typically that new capital is only allocated to new positions, or as additions to winning positions. The thinking here is that stocks which are doing well should continue to keep doing well, which warrants the purchase of additional shares. This has the effect of increasing the cost basis for the investment, but amplifies future gains due to the higher number of owned shares.
The problem I see with this approach is that it doesn’t take into account what the fundamentals of the company are suggesting the investor do. Just because a stock has climbed 30% does not necessarily make it a suitable candidate to add to the position. In fact, it is often just the contrary as some investors will begin to take profits which might cause the stock price to fall.
I do agree 100% with cutting losses on a losing investment, however I don’t agree with the ideology that just because a stock has dropped X% or Y dollars that it means it’s future prospects are doomed. I believe that investment decisions should be made on the basis of the fundamentals and future growth prospects of the company, regardless of what stock price has done in the immediate past. By accepting this mindset, it opens up some distinct advantages through an averaging down strategy.
If you like it at $50, you’ll love it at $40
While I hate this particular expression, it does make a good point. It’s premised on the idea that as value investors, we understand that price and value are not the same thing. I’ve written another post on this subject that outlines the key differences. If we know with near certainty that the value of a stock is $60 for example, then we would be smart to buy as much as we can at $50. Let’s say the price now drops to $40. As long as the intrinsic value of the stock has not changed, then we should be still aiming to buy as much as we can at this even better price! The danger here is in not recognizing the situations where the intrinsic value has dropped, perhaps due to an underlying problem in the company, and you are no longer buying a $60 stock for $40. You may now be buying a $30 stock for $40 which is going in the wrong direction.
Adding to a position as the price decreases is called averaging down, and serves to decrease the cost-basis for the investment. For example, if we were to buy 100 shares of company XYZ at a price of $50/share and were to buy an additional 200 shares at a price of $40/share, our overall cost-basis would be calculated as follows:
- Initial purchase: 100 shares x $50/share = $5,000
- 2nd purchase: 200 shares x $40/share = $8,000
- Totals: 300 shares purchased at a total cost of $13,000
- Cost-basis: $13,000 / 300 = $43.33 / share
In the above example, we’ve excluded expenses such as commissions for simplicity’s sake. What this means, is that now instead of $50 being the breakeven price for this investment, now any price higher than $43.33 shows a profit. We have averaged our price down to a lower level, and the benefit is potentially higher profits. I want to re-emphasize the danger here. The danger is that the underlying value of the investment is no longer higher than the cost-basis, and the stock never recovers above the cost-basis. In a worst case scenario the investor might keep adding to a position as the stock drops all the way to zero. It is these situations that fuel the cut your losses mentality, as they can and do happen regularly.
A Specific Averaging Down Strategy
Let’s look at a specific strategy that could be employed by value investors to obtain the benefits of averaging down. Firstly, a proper capital allocation strategy must be in place. While I am not a believer in over-diversification, it’s important that no single investment will devastate the entire portfolio in the event we do misjudge the intrinsic value of a company and throw good money after bad. Next, a set of rules are defined that dictate how positions are opened and added to:
- Maximum total capital to be allocated to the investment is defined, for example 5% of the portfolio size.
- The capital allocated to the investment is subdivided into pieces, each representing the amount that will be invested in each purchase. For example, if $40,000 has been allocated to a particular investment, we may decide to allocate $10,000 to the initial entry, and a further $10,000 to each of three additional purchases of more shares over time.
- The initial entry is made at a predefined target entry price, defined as the intrinsic value of the company, discounted by an appropriate margin of safety.
- Prior to each additional purchase, a reevaluation of the intrinsic value and corresponding margin of safety must be made. An increase in position size is only justified so long as the proposed purchase price is below the current intrinsic value less the current margin of safety (both of which could change from the initial entry conditions). With this in mind, additions to the position are triggered by the following two circumstances:
- Each time the stock drops X% below the entry price, for example 5%.
- At a predefined time interval, for example bi-weekly.
- A separate position management and exit strategy must be in place, and must provide a means of limiting losses in the event the fundamentals of the investment no longer support the current position size.
We follow our value investing workflow and determine the intrinsic value of the ABC Company to be $100 / share, and based on our level of confidence in that number, a 25% margin of safety is warranted. This defines a target initial entry price for us of $75/share. Our overall portfolio size is $500,000 and we decide to allocate 10% ($50,000) of our portfolio towards the acquisition of shares in ABC. Furthermore, we decide to employ and average down entry method, whereby the initial purchase will be 40% ($20,000) of our allocated capital, and we will average down a maximum of three additional times, each for an additional 20% ($10,000) portion. Additional purchases will be based on a 5% drop in price or monthly, whichever comes first.
Let’s look at a scenario of how this might play out:
- March 1 – Target entry price is hit and we purchase 267 shares @ $75 / share.
- March 12 – Price has dropped to $71.25, a 5% drop from the initial purchase price. We purchase an additional 140 shares at this price.
- March 18 – Price has dropped to $67.69, a 5% a further 5% drop from the March 12 purchase. Upon a reevaluation of the intrinsic value however, we find that it has dropped to $90/share due to lower earnings than expected. Our new maximum entry price is a 25% margin of safety on $90, or $67.50. Since the current price is higher, we don’t add to the position at this time.
- March 19 – The next day however, price does hit $67.50 and we purchase an additional 148 shares.
- April 19 – A month passes, however ABC is currently trading at $72/share. We recalculate intrinsic value, MOS, and determine that the entry price is still $67.50 so we do not buy at this time.
- May 19 – Another month passes. Now ABC is trading at $67. Another look at intrinsic value and MOS reveal that the entry price of $67.50 still holds. We invest the final $10,000 of our allocated capital to this position with the purchase of an additional 149 shares. We now own a total of 704 shares at a total cost of $49,973 (excluding commissions). Our cost basis is $70.98 / share.
- December 15 – The stock price has appreciated dramatically and is now trading at $105/share. Our exit strategy dictates that we close the entire position and take profits at this price. We sell 704 shares at $105 for total proceeds of $73,920 and a profit of $23,947 (47.9% simple return).
This was obviously an ideal (and very profitable scenario), but let’s have a look at some alternate entry strategies for comparison:
- Buy & Hold – entire $50,000 invested on March 1 at $75 / share. This is a common investment approach for long term investors. 666 shares would have been purchased, which on December 15 would be worth $69,930 for a $19,980 unrealized profit (40% simple return).
- Strategy w/ 10% stop loss, $20,000 initial investment and additional $10,000 purchases for every 5% increase in share price – In this example, 267 shares would be purchased on March 1. However on March 19 price dropped to $67.50 triggering an exit from the position at a loss of $2,002. This is a simple return of -10% on the invested capital of $20,000 and a simple return of -4% on the total allocation of $50,000.
- Strategy w/ 20% stop loss, $20,000 initial investment and additional $10,000 purchases for every 5% increase in share price – This time the stop loss is set far enough away that it is presumably not triggered. Total shares purchased are 267 @ $75, 127 @ 78.75, 121 @ $82.68, and 115 @ $86.81. In total, 630 shares are purchased and the cost basis is $79.39 / share. On December 15 the investment is worth $66,150 for an unrealized profit of $16,134 (32% simple return).
Again, this example was tailored to emphasize the potential advantages of an average down strategy for value investors. It’s only purpose should be to illustrate the effect that entry and position management strategies can have on investment returns. In the example above, the simple return on the investment ranged from a 4% loss to a gain of nearly 48%. Any strategy can result in a significant loss or a gain – it’s a matter of tailoring the strategy to match the investor’s personality, risk tolerance, and goals.
The image, “Double Down Arrow” is copyright © 2012 Everaldo Coelho and made available under a GNU Lesser General Public License.