Picture yourself at a discount store. You've been looking for a beautiful, sporty, summer jacket. After some searching, you find just the one you've been looking for. The stylish black jacket will look great on you on a breezy summer night. The best part is it is 20% off. You get so excited that you pick up two and bring them to the register. The young lady behind the counter tells you some exciting news. "Sir, this item is eligible for an extra 30% off!"Wow, isn't life grand? First, you got a 20% discount and now the price has fallen even further! What a deal! You decide to go back and buy three more jackets reasoning you could make a hefty profit reselling them.
Did you like that little story? Good. Make sure you forget it because it does not apply to the stock market. Most people take what works when shopping and try to apply it to the stock market. I loved this stock at $500; it must be a real bargain at $400! Unfortunately, this is an extremely dangerous strategy. Let's go into an example.
You buy stock XYZ at $100. After a few weeks, it is down to $85. If you liked it at $100, you love it at $85 since you think you are getting more of it at a discount. Soon, it falls to $75. You decide to buy more. After a short rally, it is down to $60. It's just got to bounce so you buy even more.
Now you are stuck. You have all your money tied up in this one position. There is no guarantee it will ever return. Your only strategy at this point is to hope and pray it rallies sharply or you take a big loss.
What's wrong with the logic of adding more to a position as it declines? A few things really trouble me about averaging down. First, there is no guarantee a stock will ever return to its old value. For every Apple or Amazon, there is an Enron that never came back. Look at 2008. Many financial stocks have yet to see their 2007 values even 13 years later. Second, averaging down locks up your capital and prevents you from buying other stocks. Why put more money into a loser when you can invest in a winner? If a stock is going down, there is a reason. I never try to be a genius in the stock market. I never think I'm smarter than the market. I simply follow the trend. In my world, the only good stocks are the ones that go up. Why is that? Because that's the only way I can make money.
Let me ask you. If you were an NBA coach, would you put your worst basketball player on the court more? If he missed his last ten shots and has had a terrible year, would you put him on the court with two minutes left in the NBA finals? Would you think he was due to make his next shot in? No, you want to limit his play since he negatively impacts your team's performance. It's the same thing with the stock market. You want to have your money in the best positions. You never want to pour more money into a loser.
Psychologically, it is draining to average down. You keep pouring money into a stock and hope and pray it will come back. Why put yourself through that sort of torture? Legendary trader Paul Tudor Jones said it best, "Loser average losers."
If you are investing for the long-term and are using a broad-index fund that tracks the S&P 500, you can get away with averaging down if you have an extremely long time frame (think decades). The reason for this is you have years and years on your side and also lots of diversification. However, averaging down into a single stock is absolute deadly. If you trade individual stocks, you must never under any circumstance average down. It's a situation almost every trader gets themselves into early on in their career until the learn the hard way to never do it again. Always remember to heed the advice of legendary trader Jesse Livermore.
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