I was on a panel at a large investment conference… there have been so many, I don’t remember the precise details. But I was up there with Doug Casey and other famous resource speculators, and someone in the audience commented that averaging down was a recipe for disaster.
I think it was Rick Rule who leaned in to his mic and said, “I’ve made a lot of money on that recipe for disaster.”
There are two outcomes:
- If you can reduce your cost basis on a stock the goes on to become a great winner, it can dramatically increase your gains.
- If you buy more of a stock on its way to becoming a loss, it becomes a much worse loss.
The problem, of course, is the no one knows for sure which it will be. We are talking about speculation, after all—though I’d argue that the same quandary faces all investors.
There is, however, and important difference between staying the course on a great speculation and simply throwing good money after bad. If there’s material bad news, exiting ASAP is the smart thing to do. At least until the dust settles.
Like what?
- A major, game-changing tax increase
- Management prosecuted for fraud
- Research or exploration fails to deliver the goods
- A coup
- Profits fail to materialize
There are a million things that can go fatally wrong in a speculation. If that happens, just get out.
But if the asset gets cheaper with no bad news other than the price fluctuation, averaging down can be a very smart thing to do. The key point is that process fluctuate all the time—especially in the highly volatile stocks that make for high-yield speculations. This means that a lower price, by itself, is not an indication that there’s anything wrong with the play.
What could cause a stock, for example, to fall dramatically if there’s nothing wrong with the company? There are a million things that can make that happen too…
- A major shareholder gets divorced or has a medical emergency and has to liquidate assets to cover the bills.
- Related commodity prices fluctuate for no fundamental reason.
- A fund that holds a lot of stock gets hit with redemptions and is forced to sell without regard to price.
- A fundamentally meaningless technical threshold triggers robo-selling.
- Another company with a similar name or ticker gets hit by scandal.
And so forth.
Of course, a sudden or persistent drop in share prices is a very good reason to have another look at a speculation. It’s wrong to assume that lower prices prove there’s something wrong, but it’s just as dangerous to assume everything is fine. So, you pull your due diligence boots on and give the speculation a thorough new review. Kick the tires hard.
If the company, asset class, bond, option, or whatever it is still looks solid, and it’s cheaper—great! If I liked it before at a higher price, and it still looks good at a lower price, then I like it even better.
Well, honestly, I like it better if I have cash to deploy. If I’m all in, it’s something to grin and bear. Payday remains just as likely as before the price fluctuation. Unless I panic and sell.
The way my mentors taught me to turn such volatility to my advantage is to never go “all in” at once.
I assume everything I buy has a chance of giving me better entry points ahead. I buy anyway, just to make sure I don’t miss the boat. But I hold some cash back, so I can average down if I get the chance.
I start by considering what would be an ideal position in, say, a stock I want to buy. That might be $10,000 for a smaller, less liquid company, or $100,000 for a bigger one with excellent trading volume.
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, 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 slices. The first and second might be equal slices on a less volatile stock, or 40% and 60% slices if I expected near-term fluctuations. For a more volatile pick, I’d typically take an initial 20% slice, then another 20%, and hold off on a 60% slice in case of a major corrections without any bad news regarding the specific speculation.
Here’s 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% initial stake. 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 stake 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 third, 60% 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 82 cents per share. I didn’t know where the bottom was, but I used market volatility to get an average price below my entry point, boosting my gains over 44%.
- Or let’s say it was a bad pick. It drops to $0.60 on actual bad news from the company. But instead of being all in at $1, resulting in a 40% loss, my average cost of $0.82 reduces my loss to about 27%.
Building low-cost positions this way can both boost profits and cut losses. It 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.
