The Worst Mistake that a Trader Can Make: Average Down

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.

Inflation: A Reason for (Not) Investing in Bonds

Most people invest in bonds because they want to have stable fixed income. Because the performance of bonds are very stable, they also serve to reduce the volatility of the overall portfolio. Depending on the weighting from 0% to 100%, you can reduce your stock volatility correspondingly. With regular re-balancing between your stocks and bonds, you should be able to “sell high and buy low” in your stock portfolio, and use your bonds as a stable source of income.

Everything sounds good so far, but the most attractive feature of fixed income is also its greatest drawback — the income is FIXED. It does NOT increase as time goes on, and inflation keeps reducing your principle and interests into nothingness. Since inflation is almost always there, you’ve got a real problem especially when you’re investing long term in long term bonds.

Normally, this problem is resolved through obtaining higher interest yield on your bonds to compensate for your inflation risk. Assuming that your obtained yield is always higher than the inflation rate, you will not have a problem. Your actual income from bonds however should be on an after-inflation basis, and after-tax for that matter.

Vice versa, if the economy is undergoing a phase of deflation (usually caused by economic recession or depression), it is very advantageous to invest in bonds. Not only do you get a fixed income while everything is falling off the cliff, but the purchasing power of your principle just keeps getting better. From 1980 to 2001, the US and the world in general experienced one of the most prosperous economic eras. During that period, the nominal inflation rate was relatively low while the economic expansion kept going strong.

In the spring of 1980, when Fed Chairman Volker hiked interest rate to stratospheric a 15% in an attempt to save the dollar from further depreciation and to put a stop on double digits inflation rate, it was actually close to the peak of inflation. When interest rates peaked, bond prices were low (interest rate increases lead to lower bond prices) and created an excellent opporunity to invest in bonds. At that time, if you had invested in bonds, you could have locked in some 10% to 15% annual yield rate for the length of the bond you purchased (like 30 year treasury bonds).

Bond Yield History from finance.yahoo.com
Source: Yahoo! Finance

After an almost 20 year bull market in bonds, I personally believe that we are embarking an era where the inflation rate is heightening (at least in the US), which will force bond interest rates to stay high if not go higher. I encourage you to study the inflation chart from inflationdata.com, a great site for historical data research, to gain some historical background. I also believe that in coming years bonds are probably not the best investment because of the huge debt overhang on the US dollar.

Bond Hedges
If you’re interested in playing against a bond bear market, one can actually “short bonds” by borrowing a big amount from a fixed term loan, such as home mortgage. Assuming that bonds are not a good investment, “shorting bonds” by having a mortgage will work to your advantage by essentially reducing your real payments over time because of higher inflation.

A riskier hedge against bonds is to invest in gold & silver and natural resources. In any case, I would suggest that instead of investing your money in bonds which generate a fixed income, you should probably invest into a dividend-paying stock, preferably one who ties its dividends to the price of natural resources. Yes, it may be more volitile, but in the long term your dividends can keep pace with inflation and the price of the natural resources. Here is a list of high yield dividend stocks, yield from 6%+ to almost 20%, mostly tying their dividends to price of gas/oil, or its related business.

TIPS are for waiters?
Protection of your inflation-adjusted principle is the most important thing in investing. There are times when investing in bonds is wise, but now is probably not one of those times. You may argue your case for investing in TIPS, treasury inflation-protected securities which have interest yields indexed to CPI. But I cannot trust a Fed that hides M3 money statistics, nor a government that uses hedonic adjustments on CPI to bail you out of inflation. Plus income from TIPS is taxed, so even if your initial income is inflation-adjusted, taxes will take their toll.

More Bond Resources
For more resources on investing in bonds, check out Chris’ article What are Bonds? here on InvestorGeeks. I’ve also posted a series of articles on bonds on my site 1stMillionAt33:

  1. Intro to Investing in Bonds: Fundamentals
  2. Intro to Investing in Bonds: How-to
  3. Intro to Investing in Bonds: Risk Factors
  4. Reasons for (Not) Investing in Bonds

Reasons for Investing in Gold & Silver

Gold & silver, or precious metals (PM) as they are referred to in the investing community, are a kind of commodity.

Physical commodity investing is not usually done as a long term investment. This is because a commodity has no value besides its intrinsic value. It will never increase in quantity nor quality as an investment or product, unlike stock ownership in a company where the corporate earnings can potentially increase with time.

So why am I investing in such stupid and “boring” investments?

My primary reason for investing in precious metal & its associated mining stocks is for the inflation protection from fiat currency expansion and its relative undervalue. Yes, gold is undervalued even at today’s price of about $630 per troy ounce. On an inflation-adjusted basis, gold needs to exceed $2090 in 2006 dollar to overcome its 1980 peak.

Gold Adjusted Chart

Comparing to price of crude oil, the price of gold is again undervalued relatively speaking. Oil has almost tripled while the price of gold only doubled since the recent low. Especially with a potential Peak Oil in the global oil production, when oil rises, gold inevitably will rise together.

Gold to Oil Ratio Chart

Comparing to Dow Jones, the cycle of paper stocks seems to be over while the cycle of tangibles like gold has begun. In fact, if you reference to the chart 13 on pg.18 of “The Return of the Bear” by Martin Pring, the well-known technical analyst, you can see that the trend line of S&P 500 over gold has been solidly broken. No matter how you parse it, either gold goes up or stocks go down.

Gold to Dow Ratio Chart

You can read more details on the arguments for investing in gold in this gold-eagle.com article by Eric Hommelberg. It has an excellent summary for investing in gold.

Fundamentals in the Coming Years
With all the huge US budget and trade deficits, how can the US government still wage wars in Iraq, while promising more drug benefits to seniors? With all the entitlement programs that need to be paid, the least painful resolution for US government is to print money by inflating the monetary supply. While the benefits don’t get cancelled, they won’t get the promised matching increase with inflation either. By essentially diluting the value of $US, the government can also dilute the real value of debts that it needs to repay. Since US consumers are also heavily in debt, devaluation of $US can shift the majority of loss to foreign holders of $US and US bonds, albeit creating more inflation due to the rise of price in the import goods. Such US currency policy, gradual devaluation with empty talk of strong $US currency, is indeed the best for US. It keeps both the US as the debtor and foreign creditors afloat temporarily, so that US can keep its spending spree by borrowing global savings. Creditors in the meantime will not face a sudden huge loss on its bond portfolio.

The US debt overhang is definitely bullish for gold and fortells that inflation will not go away anytime soon.

A Technical Picture
Some people claim that precious metals have made its top in the recent bubble run, and it should be downhill from now on. I disagree strongly. Although the latest run up in PM is quite parabolic (one of the characteristic for financial bubbles), based on the percentage ownership of all market participants, I believe that the bubble has barely begun yet if there is one. At the height of a bubble, not only the news should be making headlines, but also mass of investors should flock and chase right into the top. However, that is definitely not the case. Instead, precious metals have corrected substantially back to the 200 days of moving average (click to see chart), and again is reasserting its bullish trend. While it is possible that gold may retouch the 200 days moving average line again later at the four year stock market cycle near September, the relative strength in precious metal market compared to the general market is simply undeniable (see chart here). I expect that any rally, especially due to a pause in the interest rate hike by Federal Reserve, will be accompanied by a stronger showing from PM market.

The Case for Silver
Many may argue that silver is not a monetary metal, but rather an industrial metal. While they may have a valid point, silver nevertheless tracks the price of gold somehow. What’s really amazing about silver is that it has been in production deficit for 60+ years, with an accumulated defict of some 10 billion ounces. The price has not increased but instead has been falling for the last 20 years. A production deficit requires a drawdown in inventory. While some silver usages do get recycled, this sustained deficit is still quite big by any measures. By the way, some people challenge the validity of the silver deficit (for example, Zurbuchen’s article). While I dare not to say how big the silver deficit is exactly, the current gold to silver ratio at about 55-to-1 is most likely out-of-line with the historical average of 31-to-1. This ratio is expected to decline in favor of silver as the precious metal bull market continues to unfold.

According to Theodore Buttler at www.silver-investor.com, the silver naked shorts at COMEX have not covered their 100+ million ounces while the market seems to have bottomed. Physical deliveries of silvers are facing delays of months, showing strain of supply. We will see whether the current situation unfolds as a supply crisis going forward.

My Own Strategy
The majority of my precious metal investment is in mining company stocks instead of physical gold & silver bullions. I invest in them for additional leverage, explained in my post on Intro to Investing in Natural Resources. And obviously, with leverage, it also comes with additional risk beyond physical bullions. To learn how to invest in gold & silver, you can check out my post on Intro to Investing in Precious & Base Metals.

Some Counter Arguments
No article will be complete without examining some opposing arguments. Here are the two best sources for counter arguments for investing in gold that I have found so far. While both are cautiously bullish on the commodity markets, neither seemed to subscribe to the concepts of Peak Oil or Commodity Super-cycle which are widely believed by commodity bulls. Both are extremely well articulated.

The first source is Commodities Rising by Jeffrey M. Christian. I have not finished the book yet, but it tries to dispel hypes in commodity investing. I highly recommend anyone to take a look and understand what are the hypes and what are the truths.

The other source is Energy Mania and Actuarially-Driven Investors & Financial Fads by Bob Hoye at www.institutionaladvisors.com. His last call to get out of the precious metal market was right on the money, and made his arguments even more convincing. He doesn’t subscribe to Peak Oil in his Energy Mania article. However, he is definitely a long term commodity bull from his interview and from his own articles.

More Information
Here are a couple of articles from the mainstream media that explain why you may want to own gold:

  1. From CNN: Hedging a decline in $US using gold.
  2. From USA Today: How to hedge against hyperinflation using gold.

P.S. I want to thank Eric Hommelberg at www.golddrivers.com for making all the figures available for this article. I myself am a subscriber to his golddrivers newsletter, and I can attest to the fact that a couple of his recommendations have truly hit the jackpot (10X return). The volatility can be extreme (+1000% to -90%) for junior mining companies if bought at the wrong time. High returns are always accompanied with high risks. I will not recommended investing in junior mining companies for any beginning investors.

Basics of Precious and Base Metals Investing

There are two types of metals for investment: precious metals as opposed to base metals. Precious metals include gold, silver, platinum, and some other less known materials such as ruthenium, rhodium, palladium, osmium, and iridium. Base and/or industrial metals include copper, nickel, aluminum, zinc, lead, and iron/steel. The reasons for investing in precious metals and base metals can be very different. But their prices are correlated nevertheless because of inflation.

Here are some ways to invest in metals:

  1. Leverage your bets in futures market. Only recommended for professional traders.
  2. For precious metals, you can try the following holding ETFs: IAU (0.4% expense), GLD (0.3% expense) for gold, SLV (0.5% expense) for silver, and CEF for about 50:50 gold & silver.
  3. You can invest in physical bullions or gold/silver coins. Check out my post on investing in silver.
  4. Invest in metals/mining stocks. This gives you some leverage compared to holding physical metals, as explained in my previous intro to investing in natural resources.

If you want to invest in physical gold/silver, my personal opinion is that physically obtaining your gold/silver is probably the best. You will need to deal with authentication of your purchase, physical storage & insurance, and deciding which forms, bars or coins. But all those efforts are worthwhile I believe. Investing in holding ETFs such as GLD and SLV are convenient, but they are still a form of paper assets. Paper assets are easily traceable by the government. If you’re investing for fear in a monetary system-wide breakdown caused by the government, it is probably preferable not to have the “thieves” watching over your money. In the history of United States, President Roosevelt confiscated gold from US citizens. In the name of protecting the power of States, the government can declare any sorts of national emergency or for any security reasons to physically confiscate your assets, or pay you with more worthless dollars for your real assets at a discounted price, or tax you so heavily either for holding or trading (currently 28%) to practically extract all the asset values that you have. There will be nothing that you can do against a much bigger power that is trying to protect its own survival. Confiscation of gold has happened before, and no one can be sure that it won’t happen again. In time (hopefully it will never come), before things start to go crazy, one should convert paper assets in the form of these ETFs & stocks into real physical assets.

There are many many metal stocks, and I will suggest that you should try the bigger market cap first. Bigger companies almost always have less upside, but also have less risk too. You still should have probably more than 5 stocks, or at least have 3 different stocks for sufficient diversification, assuming that you don’t use mutual funds or ETFs.

For the base metals, here are the stocks that you can look into:

  1. Copper: PD, PCU, FCX (also a very good gold stock)
  2. Aluminium: AL, AA
  3. Nickel: N, NILSY.PK
  4. Steel/Iron: RIO, TS, MT, PKX, NUE, GGB, X
  5. Diversified metals: BHP, RIO, RTP, FAL (being acquired by N)

For silver, you can look into PAAS, CDE, SIL, SLW, BCM.V, SSRI.

For gold, you can look into ABX (not really recommended, due to its heavy hedge book), NEM, FCX, AU, GFI, GG, HMY, GLG, MDG, BVN, KGC, LIHRY, AEM, EGO, BGO, IAG, GOLD, RGLD, CBJ, AUY, GRS, VGZ, NXG, NG, NAK, SA, NSU, etc. There are indexes that you can use for your trading and investing references: XAU (Yahoo’s symbol is ^XAU) and HUI (^HUI in Yahoo). Please note that you can click on both indexes which are market cap weighted. And if you want to invest in gold stocks ETF, there are XGD.TO, or GDX (I got the weightings from billcara.com).

If you buy individual stocks, pay attention to the physical locations of the mines. The local currency exchange rates have screwed the performance of GFI, HMY, and PDG in the past. Right now, currency exchanges are helping GFI, HMY. Read my post on Intro to Investing in Natural Resources for details in the effect of currency exchange rates. And the most important thing about physical location is the political stability. KRY just got sacked recently because of politics. In general, geographic stability and diversity is very positive for the miners.

For precious metal mutual funds, you can get the list from the Yahoo’s fund screener. I personally hold GOLDX and TGLDX (historically a slightly more conservative holdings including moving to cash on sideline and sometimes have gold bullion). UNWPX is more aggressive, and seems very good to me, the choice by investmiddleway.blogspot.com. I personally considered seriously about VGPMX (too much energy-like, such as BTU and CNX), and BGEIX (over 7% in ABX, track XAU index most of the time), but didn’t make any purchases at the end.

From my personal investing experiences, I recommend everyone to use mutual funds and ETFs as their core positions in this precious metal sector, and mix & match using individual stocks for tailoring personal taste. For more active traders, they can use more ETFs as their core positions rather than mutual funds. My personal goal is to move to the following allocation, because I currently hold too many individual stocks, and my time is very limited for investing:

  1. Total of 5% to 15% in “physical” precious metals such as GLD, SLV, and/or CEF. Between gold and silver, I will probably allocate about 40% gold and 60% silver.
  2. The rest goes into equity market. I will probably have 25% to 35% in gold mutual funds, 30% to 35% in ETF (except that just having GDX may not be such a good idea), and the rest I will use individual stocks for tailoring.
  3. In the equity portion, I will probably allocate 60% to 75% in gold and 25% to 40% in silver.
  4. In the equity portion, I would like to allocate 65% to 75% to major producers, and 25% to 35% to mid/junior producers and/or exploration companies.

Obviously, the above is just a goal. It may not be possible to fulfill every criterion. Using ETF and stocks will be better for trading & tax, assuming that you don’t want to initiate separate short positions against your mutual funds. And it also depends on your size of portfolio. The smaller the portfolio is, the less flexibility you have. I would also advise a minimum of 5% of your total networth to be put into precious metal sector. Depending on how aggressive you are, or how nervous you are about $US depreciation, you could go to 15% to 20%. I would not recommend anyone doing what I am doing, currently having about 25% of my networth in precious metal. The primary reason that I can afford to do such allocation is that on a leveraged view of my networth, the precious metal allocation will drop to below 15% which is the true effective influence on my leveraged portfolio.

You can study more stocks in the Yahoo’s finance database for basic materials sector.