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Averaging Down: Playing Chicken With Mr. Market

4 October 2006 1,414 views 5 Comments

In case you doubt my membership in InvestorGeeks, I love movie trivia! What’s the highlight scene in James Dean’s 1950s cult movie, Rebel Without a Cause? You are right if your answer is the game called chicken, where Dean and his rival each drove a car towards a cliff. There are many variations of the chicken game, but in the movie, the game is won by jumping from the car later than the other player; but still in time to avert the cliff. For investors, it sometimes feels like your rival is Mr. Market daring you to jump out of your car first. The person who blinks first loses, but if you don’t blink, you might lose even more when you fly off the cliff! Sounds familiar?

I bet many investors out there have had the situation where you did all your homework before buying a stock and yet it still tanked 10%, 20% after you bought a position. It happens to the best of investors. What’s a person to do in this situation? Should you buy more? Should you get out early?

Stop-losses can certainly help, but it almost feels like you’re blinking first, letting Mr. Market win. But then again, you don’t suffer the “ultimate loss”. For most value / contrarian investors like myself, the decision to buy a position does not come easily. A lot of analysis was completed prior to pulling the trigger. What you thought was a good buffer, a good bottom with very little downside still manages to prove you wrong. It sometimes feels as if you should wait out Mr. Market to win the game. And for the average-joe investor, stop-loss may not be a common tool in their arsenal.

2 Different Schools Of Thought
Everyone can argue about what is the right answer. What if stop losses blind you from making an otherwise good decision to buy more? What if trying to out wait Mr. Market is the wrong choice?

I recently blogged a discussion between two fund managers whom I respect. They also had different thoughts on the concept of averaging down on a losing position; catching a falling knife so to speak. So the topic is not just debatable among us amateurs! Here are the 2 differing opinions:

  1. Never average down a losing position. Don’t throw good money out the window. If you’re going to do that, wait for a real wash-out. But don’t keep doing that, that’s a terrible way to invest.

  2. If we bought a stock at $10, and it goes to $8. We go back to the drawing board. And if the market is a little off-kilter, and we still think we’re right. I’ll buy more.

There Is No Right Answer Unless It Fits You!
I was tempted to write out my lists of when to average down, and when not to average down but realized that whatever answer I put up may not fit you because of one important quality – an investor’s temperament!

Whether you are a technical investor or an fundamentals investor, temperament is the single most important quality that you must possess. If you do not possess the temperament, discipline or analytical skills, consider implementing a system that you must follow (such as stop losses) to help remove the emotion from your decisions. You might blink first, but you won’t lose out!

You might have guessed that I belong to the camp where I need to re-evaluate my initial premises to see if I missed key information. I would average down if I still remain very comfortable with the re-analysis, but would probably wait for a stable entry point. And I would not hesitate to exit a position if the re-analysis showed something different. As I always say, “buy when it’s right, sell when it’s right”! I don’t like to play to lose, but I also realize that you can’t win it all!

Even though I did not write out my lists of knowing when averaging down is sane or insane, I know our InvestorGeeks readers are smart enough with their own triggers. Where do you stand on averaging down? I may be tempted to post more of my thoughts on the issue in the comments if the discussion gets good!

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In case you doubt my membership in InvestorGeeks, I love movie trivia! What's the highlight scene in James Dean’s 1950s cult movie, Rebel Without a Cause? You are right if your answer is the game called chicken, where Dean and his rival each drove a car towards a cliff. There are many variations of the chicken game, but in the movie, the game is won by jumping from the car later than the other player; but still in time to avert the cliff. For investors, it sometimes feels like your rival is Mr. Market daring you to jump out of your car first. The person who blinks first loses, but if you don't blink, you might lose even more when you fly off the cliff! Sounds familiar? I bet many investors out there have had the situation where you did all your homework before buying a stock and yet it still tanked 10%, 20% after you bought a position. It happens to the best of investors. What's a person to do in this situation? Should you buy more? Should you get out early? ">
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5 Comments »

  • christopher baus said:

    IMHO if you can’t stomach a 10% short term loss you should really consider treasury bonds. You use the term Mr. Market which was coined by Benjamin Graham, but I’m pretty sure that if he thought a stock was a good buy at $10, he’d find it a better buy at $8. There are traders and there are investors.

  • Steve said:

    This is one of the things I don’t understand about value investors, and as Christopher said, if you felt a stock was a good buy at $10 you would always buy more at $8 because the fundamentals told you $10 was a good buy. Everything below that should be a better buy, and if you’re buying good companies, it usually is.

    However, if a stock is tanking like that, it might be good to get out, move the cash to a better investment that’s going up and then wait and re-buy the stock at it’s bottom. Why continue to take on losses in the hopes that you dollar cost average back to a good place? I’d rather realize I bought too soon, move my cash to a positive position and come back to this position when it’s moving positively.

    To me, it’s a very key point that even if you buy a stock at $10 and it stays at $10, you’ve lost money. Not only did you lose 4% or so to inflation, but you lost money due to the opportunity that money had to have made money, even if it was in a CD for 4%.

    A few stocks I’ve doubled down on a dip, WWE comes to mind and I made a killing on it, but in the end, to me, it comes down to the size of the dip and the other opportunities around me. I dumped Dell to hop into OPSW. I wasn’t down more than 4% on Dell, however, Opsware was a better investment, so I dumped Dell, moved to Opsware and rode it up $3.75 so far. I can always get Dell back later.

  • Vince (author) said:

    All good questions.. let me attempt to answer

    Value investors by nature do not pull the trigger easily. They search high and low for a low risk entry point. From a risk/reward quadrant, they want to stay in the north-west quadrant as much as possible. It would be common sense to find another stock to invest in while your stock tanks, and I’m sure people have done that, but I also believe it’s because they don’t have any trigger to pull while this is happening! Their watch list may be long, but the entries that allow value investors to feel comfortable about buying a position is a very narrow list.

    My mantra is to “sell when it’s right”. One of that test is if you see a better opportunity available elsewhere, by all means you should do so! This is another reason for me not to average down.

    As for buying lower being always the right decision, not always… fundamentals may change and your analysis may be different. For example, if you held the stock of a CD player manufacturer, and it cashflows well, low debt, but is undervalued, the value investor may be tempted to buy. However, upon re-evaluation, we realize that management is staunchly against moving to manufacturing MP3 players (I don’t know, just an example), that fact may change your entire analsysis. Value investors as analysts are not infallable. If you realize your initial analysis was way off, you might not want to average down.

    Basically, I don’t believe always averaging down is right.. or always not averaging down is right. I don’t believe in staunchly following extreme processes. I’m not an extremist. I believe in being flexible and treating each situation in the best way possible.

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