InvestorGeeks

If I’m forced to select only one thing about stock trading to tell you, this is it: do NOT average down. This is not to say that averaging your cost basis on the way down never works. But more often than not, averaging down is a bad decision on top of a wrong one already.

A wrong investing mentality
Most novice investors buy individual stocks like buying any other merchandises. When it’s on sale, they buy even more. When the individual stocks are cheaper, they must be a better deal. It seems to be good common sense, except that stock is not merchandise. Stock is business ownership. When you buy stocks, you must be in the mentality of investing in good business, instead of buying cheap merchandises. So when a stock goes down in value, it usually means that the business is expected to go downhill. Unless you can convince yourself that the market may have the right opinion in the short term but definitely not in the long term, otherwise you should not be averaging down by continuing to buy a stock that is going downhill.

In love with your stock
You are so convinced about your own opinions about a stock that you are not looking hard enough for any counter-arguments. Or you are simply not thinking objectively. Never be in love with your stock. Stocks come and go, and they are just an instrument to allow you to preserve and grow your wealth. They are not you. They don’t need to be a part of your money. They are just a tool. Do not be so in love with your stock, such that you keep averaging down.

Failure to acknowledge your own mistakes
Beginning investors think that if they don’t sell, they don’t incur the loss. WRONG! Always mark your portfolio to the market prices. Do not live in your own virtual reality. A loss that is not booked yet is still a loss. With a trade that has gone bad, you don’t correct that mistake by lowering your cost basis through averaging down. Understand your mistake. Making the same mistake over and over is the cardinal sin of stock trading. Suppose that the mistake is that you bought the wrong stock (or at the wrong time). Now if you keep making the same mistake over and over, do you think it is more likely to get better or get worse? It is better to admit your mistake and move on. When you average down, essentially you have not admitted your mistake. Instead, you bet your money again in attempt to tell Mr.Market “Here is the punch in your face. I’m going to show you that I’m more right than you.” But I got to tell you that Mr.Market is just the market. Market price is what it is. It does not care whether you are right or wrong. There is only one price, and it’s the current price. And either you are losing money or gaining money due to the current price.

It’s about getting even
No, you don’t get even with Mr.Market. The more emotional you are, the less successful trading you will be doing. You can make the loss up by looking elsewhere. Do not stick out your head for the same falling knife (stock).

Concentrated position in a single stock
When you average down a stock, most of the time, you are buying more than you initially intended to. Your portfolio composition starts to skew towards this concentrated position. One of my work colleagues averaged down in a stock for about 4 years. Finally after 4 years, he was out of red losses. In his portfolio, he had pretty much just 1 stock. I don’t mean that averaging-down will never work. But for such scenario, you need to have A LOT of money to keep averaging down your cost basis, and the company must NOT go bankrupt. Taking such undue risk is simply unwise. My colleague had A LOT of money certainly, and he was lucky that the company just almost but did not go bankrupt. Such betting is close to gambling for a 50% of Even/Odd with 2X payout. If you have an infinite amount of money, you will never lose. You just need to bet $1, $2, $4, $8, $16, $32, $64,…. at an exponential increase in bets. Eventually, you can always win and get back all of your previous lost money.

So under what scenarios averaging down can make good trading sense:

1. Averaging-down was planned ahead: A planned averaging-down means that the very first move into the stock was not the full intended allocation for the particular stock. Rather because of the great uncertainty in the market, you have chosen to take small steps at a time, and time-diversified your entries into this particular stock. Once a full allocation is reached, you do NOT keep averaging your basis. You take a full stand, and that’s it.
2. Averaging-down after thorough technical and fundamental analysis: Assuming that your later decision of buying the same stock stands on its own, and was independent and unaffected emotionally by your previous mistake, then supposedly buying this particular stock this time is as good as any other times. You have done your due diligence. And you are simply acting according to your logical and objective analysis.
3. Averaging-down not for individual stocks, but for the general markets: investing in the genral market indexes is better than individual stocks in the sense that individual companies can go bankrupt, while market indexes in all likelihood will not go bankrupt. Averaging your cost basis for your investment in market indexes is okay, as long as your investment horizon is very long term. Having a very long term view on your investment can bring more calm to your mind, away from the day-to-day swing. You are in the market for the long haul, and you are averaging down only because it makes sense.

Personally, I seldom average down for my trades. When my trades don’t go as I expected, I either hold or fold. If I’m wrong, I’m wrong. I don’t want to make the same mistake again. If I’m right, eventually market will agree with me, and make my trade back to a winning trade. I don’t want to average my way down for all of the above reasons. Majority of my averaging down is because it was in the plan.

A conservative investor should FOLD. Only aggressive investor double down to average. An investor with a longer horizon can hold, with extra vigilance.

Nathan Lin, better known as "Frugal" among personal finance bloggers, maintains a website at www.1stMillionAt33.com to share his investing & personal finance tips & tools. By sharing his thoughts with readers, he hopes to inspire & enable them to become wealthy, if not a millionaires. Nathan is an engineer working out in California and gladly participates as an InvestorGeek with his 10 years of casual investment experiences.