During a Q&A session at a large investment conference some years ago, someone in the audience dismissed averaging down as a categorically bad idea. I remember legendary speculator Rick Rule chuckling and saying that he’s made a lot of money on that bad idea.
A famous example from his experience was doubling down on Paladin Energy (PDN.ASX), a uranium stock that ended up rising over 17,000% in the last big uranium bull market.
One from my own experience would be when First Majestic Silver (AG, FR.TO) fell off a 50% cliff after it dropped one of three large projects on disappointing results. I don’t have access to trading data from my previous employment, but I recall that opportunity turning into a 20x winning trade.
So, what is averaging down and why should one consider it? When should one do so? And is there a right way to do it?
Let’s have a look…
What and Why
Averaging down is simply putting more money into an investment that’s selling for less than when we bought in.
That sounds like throwing good money after bad. And it’s true—if the investment never recovers. Refusing to give up on a failed investment and compounding the error by putting more money into it has destroyed fortunes.
But the opposite is true as well—if the investment turns out to be a winner. Averaging down lowers our average price, or cost basis, increasing the eventual gains. Doubling down on a misunderstood or overlooked investment has made fortunes.
The question isn’t really whether or not averaging down is a good idea. It’s not even confidence alone. Confidence in a bad idea magnifies its destructive capacity.
It’s how good we are at picking winning investments that matter the most.
How do we know if someone—ourselves included—is good at picking winners?
Track record. There is no substitute.
This is all pretty obvious, but there’s another aspect of averaging down that’s not always appreciated: averaging down helps us to buy in the first place. It makes a huge difference to the psychology of buying, if we do so while planning to average down if given the opportunity.
If I’m thinking, “I’ve only got one shot at this,” or, “I’m going all in,” timing my entry becomes excruciating. I want the best possible price, so I may miss the boat while holding out for lower entry points. Or, having bought a large position at what I thought was a great price, I may have no cash left when I’m offered a significantly better price.
In contrast, if I think of my initial purchase as a first stake in an investment position I want to build over time, it takes these risks off the table.
I literally can’t miss out entirely. And, unless I spend all my money on something else, I will have the cash to graciously accept better offers should I be so lucky as to get them.
Building low-cost positions makes volatility a valued friend instead of a feared enemy. This makes it easier to hold on to our courage, stand by our convictions, and see our speculations through to their conclusions.
When
Conceptually, we want to average down when nothing about an investment has changed except for significantly lower prices.
That benefit is easy to see when it’s clear that value has not changed, but price has. For instance, if I like prime steak or my wife loves black caviar and either one of those is offered at lower prices for the holidays, we’re likely to buy more. We get more bang for our buck.
The benefit is the same, if more unsettling, if value has decreased, but price has fallen much lower. If gold, for example, drops 1% but shares in a gold miner drop 5%, the value of the gold miner is higher relative to gold than it was before.
And the benefit is still the same—though less certain—if we’re speculating on future value that we think remains unchanged, but prices fall before we get there. A case like this would be silver dropping 5%, causing shares in a silver exploration play to fall 50%.
In any of these cases, as long as we’re highly confident—based on a strong track record—that an investment will sell at higher prices in the future and is currently selling for less than we paid initially, averaging down makes sense.
It’s vital to remember that averaging down is only a good idea if nothing else material has changed other than prices being lower.
Suppose a company’s drug fails to receive FDA approval, or a mining project fails to get permits, or exploration drilling fails to turn up the goods, or a lemonade stand fails to make money…
Lower prices are a correct response to failure, and recovery is rare.
Yes, there are examples of failed projects becoming successful after a reboot. But there are more failures that never recover.
When failures do turn around, it’s almost never simply on the basis of more money being invested. Heads roll. Prototypes get redesigned. A new geological interpretation is applied. The effort becomes a new project—a new investment.
That’s fine, but turning failure into success is never the most likely outcome. Investors are right to be doubly skeptical of projects and people who have failed them before.
How
When I’m ready to buy, I buy only part of my ideal position. If the stock takes off the next day, at least I have a stake and will benefit. More likely is that the stock will fluctuate in the days or weeks ahead, and I’ll have a chance to buy a second slice of the pie at a lower cost.
Depending on how volatile I expect the stock to be, I might buy it in two or three lots, which I call stakes.
If the stock is less volatile, my first and second stakes might be equal 50%–50% slices. Or they might be 40% and 60% slices if I think the odds are high for big fluctuations ahead.
For a more volatile pick, I might take an initial 30% stake, then another 30%, and hold off on a 40% slice in case of a major correction without any company-specific bad news. If the correction is big enough, the final 40% stake could add more shares to my position than the 60% in the first two stakes.
For an extremely volatile pick, I might take a much smaller initial 20% stake, then another 20%, and hold off on a 60% stake in case of a misguided selloff. Or if the story improves, it might go 20%, 30%, and 50%.
There’s no single correct formula for this. The size and timing of my stakes will depend on our individual appetites for risk, cash positions, and the actual progress of the company/investment in question.
Let’s walk through an example:
- Let’s say my ideal position in Company X is $20,000. It sells for $1 per share when I decide to buy. It’s a more volatile stock, so I decide on a 20% first slice. I buy 4,000 shares for $4,000.
- Nothing happens to the company, but the stock rises for a while, then drops to $0.90. I buy a second slice of $4,000, which adds another 4,444 shares to my position. The stock takes off again based on solid, value-adding results, and I’m happy. I already have a good 40% of my ideal position, and the stock is doing well.
- The next week, there’s a big scare in irrelevant financial news that puts all stocks in this sector on sale. Company X shares drop to $0.75. I’m even happier, because the company is more valuable than when I started, but it’s even cheaper, making it a better value. I buy my 60% third stake, picking up 16,000 shares for $12,000. More ups and downs follow, but I’ve got 100% of the pie I wanted, so I sit tight.
- Now let’s say I made a great pick and the stock doubles to $2. Great! I bought 24,444 shares for $20,000, averaging $0.82 per share. I didn’t know where the bottom was, but I used market volatility to get a low average price, fairly close to the bottom, boosting my gains over 44%.
What if a stock I’ve already averaged down on falls off a cliff for all the wrong reasons… would I consider a fourth stake? A fifth?
Generally, no.
The resource sector is so volatile that I’ve been able to average down substantially in one or two stakes.
Can one average down too much?
Yes, I think so. If an investment keeps falling and falling—especially if others of a similar sort are rising—I have to ask myself if I’ve made a mistake.
But I don’t think I’ve ever had that happen to me. I’ve made mistakes, of course, if memory serves, but I’ve yet to average down and take a loss.
As I write this, I do have one stock in my current portfolio I’ve averaged down on twice and would consider buying more if nothing else changed and a stock market crash put it on sale. But it would require something of that magnitude.
If there were a lesser but still substantial retreat—say, gold falling below major psychological support levels and staying there for some time—I’d be more inclined to average down on all the other stocks I still have only small, initial stakes in.
The bottom line here is that as long as our basis for speculation remains sound, lowering our cost basis when we can do so meaningfully is a good idea.
And averaging down in a big way when we’re lucky enough to be offered fire-sale prices for the wrong reasons can be the making of a fortune.
That’s my take,
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