Averaging Down: Playing Chicken With Mr. Market
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:
- 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.
- 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!