“You buy stocks on the way up in price, not on the way down. And when you buy more, you do it after the stock has risen from your purchase price, not after it’s fallen below it.” – William J. O’Neil, MarketSmith Founder
Averaging down in a falling stock is like lending money to your brother-in-law.
Your wife insists and you are left with no choice but to lend him money. Months later he needs more money. You may lend him more, but you surely must feel sad about watching that money going out, knowing you will never see it again.
In the stock market, you have to quickly admit when you are plain wrong. If you can’t do that, investing could become an expensive hobby for you. In growth investing, throwing good money after bad is never a good strategy.
Still, you must have heard this idea a hundred times from a hundred different people: If you buy a stock and it goes down, buy more. As you buy it cheaper, your average cost declines.
When the stock finally turns around and rises, you have more shares at a lower price than would have been the case if you had just frozen up and held your original position.
So what’s wrong with this approach? Everything.
First of all, you are buying a stock that’s falling. Wouldn’t you rather be buying a rising star? Isn’t that why you’ve been screening for that handful of potential winners?
Second, by averaging down, you will end up with more shares of a loser than you had originally planned. Your portfolio could become dominated by bad stocks.
Perhaps worst of all, you would be inviting disaster. And in the stock market, such invitations may well be answered.
The big assumption in averaging down is that the stock will, at some point, turn around. What if it does not? Your portfolio will be decimated, and you will rue the day you ever started trading stocks.
To win in growth investing, add positions in stocks that are rising soon after their breakout. That’s how a true leader acts. Averaging up in a rising stock gives you a chance to compound your gains.
Do some stocks never recover? Of course they do. But, no one knows how long would it take for such stocks to come back to higher price levels. In such cases, an investor is better off in deploying his capital to stocks that are doing well rather than waiting for the losing stock to turn around.
Let’s look at the example of Federal Bank, one of India’s fast growing private banks with strong presence in the state of Kerala.
We added Federal Bank to our model portfolio on October 16, 2017 after the stock broke out of a first-stage consolidation base pattern (marked 1 in chart). However, the stock failed to generate momentum and witnessed profit-booking in subsequent sessions. The stock breached its 50-day line on November 7, 2017 and also hit our stop-loss mark of 8%, resulting in a removal from our portfolio (2)
Since then the stock has corrected by a staggering 18%. Now, imagine if you had averaged down and bought the stock on every dip. You would have been scratching your head thinking what went wrong.
In this and countless other examples, you would do infinitely better to cut your loss to no worse than 8% from your buy price. If the stock turns around, you can get back in. If it doesn’t, you will have a far healthier portfolio and you will still be able to sleep peacefully at night.