One highly dangerous investing approach all investors in growth stocks ought to think over is averaging down.
This approach means buying a stock, watching it drop and then buying more shares, with an aim to lower your average buy price.
It is one of the biggest myths in investing, particularly for high-growth companies. Don’t confuse it with the cost-averaging method of long-term investing in a mutual fund or broad-based equity ETF.
When a high-octane growth stock has topped, rarely does it come back quickly and lead the next market uptrend. In fact, many stocks don’t approach their all-time highs for years.
You might hear people tell you that averaging down is a great idea, but in reality, it is generally a risky way to operate.
These folks will say something like: “If you liked a stock at 700, then you should love it at 600.” They could be referring to a former high-performer such as Kajaria Ceramics.
That makes some sense, but here is another way to think about it, which could save you some pain: If a stock has fallen below your purchase price, then it is quite simply a losing investment. When the losses approach 8%, cut the stock loose and find a better one. You can sell the stock even more quickly if you judge the price and volume action to be negative.
What if you ignore MarketSmith’s golden sell rule and instead opt to follow the stock lower? It means buying more shares could amount to throwing good money after bad, as the saying goes.
Let’s say you had bought Kajaria Ceramics in September 2017, when the stock cleared a possible buy point at 729.90 (marked 1 in below chart).
However, the breakout did not provide much upside, and pretty quickly you would have had an opportunity to average down.
This example illustrates why averaging down is often a bad strategy. Kajaria Ceramics continued to drop, so you really would have been throwing good money after bad if you added to your position in November 2017 (2) or December 2017 (3) or later.
You should have been selling your original position to avoid further losses rather than adding to it. In subsequent months, Kajaria tripped some key sell rules, such as falling 8% below its pivot price and penetrating its 50- and 200-DMA.
Also, there is a big opportunity cost. By keeping your money in a laggard, you are losing the chance to invest in a market leader. Have a look at Kajaria’s weekly chart and how the stock has remained in a downtrend for almost a year (4).
Related: Using Charts To Time Your Selling (Video)
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