When we like to buy a security at current prices, we should love it at lower prices and buy more accordingly. This thinking has some merit and is called averaging down. But it is not without risks…
One of the most useful reads I found so far is a post from Bronte Capital, discussing many aspects of the issue when and when not to average down. Below I am going to discuss what is averaging down, when and when not to do it; and review a real life example.
What is Averaging Down?
To buy more shares at lower prices than your average buy price so far, this is a quite simple definition of averaging down — not everything in investing has to be (made) complicated. Averaging down, in effect lowers your average buy price for the total position in the specific security. Additionally it increases the absolute invested amount in the security, amplifying directional changes of future price movements.
Obviously, averaging down is nice, if (and only if) the price of the underlying security is recovering eventually. But we can never be sure of that future development. Thus obviously…
Averaging down can turn out to be catastrophic, if the price is not recovering. Averaging down always increases your dollar amount invested in the security. Remember, when we are still averaging down, the recovery has not taken place yet. It is easy to understand the dangerous dynamics for absolute and relative performance when thinking of a stock going to zero: You will lose every single dollar (or euro) invested in this security. So, the question becomes …
When (not) to Average Down?
Averaging down is forbidden if we are not confident about our fair value estimate. It is also forbidden, if our current position if too high, already.
Even if we have found a high quality business and we are super confident that the business will have a positive fundamental development going forward, we do not know the future. Some uncertainty remains. Always. Making it easy for you and me: Just imagine the business you fell in love with to be a total fraud… Wirecard anyone?
Averaging down seems more reasonable if we deal with a high quality/conviction company. Even in such a situation, we should probably ask under what conditions or assumptions the company might not represent an attractive investment opportunity right now? But even companies we perceive as businesses with the highest quality and to be significantly undervalued have to be subject to our strict position sizing* rules. Maybe other investors are aware of some underlying problems, that you do not know about (yet). So the question becomes …
When to Average Down?
We are only allowed to think about averaging down a position if we tick each of the following checkboxes.
- Invested amount and market value of the respective position is within our defined limits*
- We checked for relevant news and our former investment thesis is still valid
- We want to own the business (not the stock)
- Our last purchase was some time ago*
The above criteria makes perfectly sense for me personally. If my position limit is reached (1) I am not allowed to invest more money. We have to stick to our limit, that is why we implemented them in the first place. (2) We do not want to invest more money into a business not being aware of relevant problems. These problems might well be the reason other investors sell their shares and the price is going down. We have to check the news and double check our original investment thesis for validity. (3) We have to look at the business first, and then ask ourselves if we want to own the business for the currently offered price. Do we want to own the business for the current price, even if the price tomorrow is lower? (4) We have to implement timing rules that clearly state when we are allowed to invest more money into a business. This is important, since the negative share performance might well be based on underlying problems. If we are not aware of this problem, time might tell us (present the problems to us).
Before averaging down a certain position and investing more money into a business, we have to compare the risk/reward relation against other available investment opportunities (ideally using our prepared watchlist).
Real Life Example
I want to use the following real life example to discuss my recent actions, averaging down into a position. Reviewing my actions should highlight some (hidden) problems and result in helpful learnings.
I bought into a position five times in total, each time at a lower price per share than before, effectively decreasing my avg. buy price — so this could serve as a textbook example. Since my fair value estimate for the companys shares did not decrease dramatically and was much higher than prevailing prices, I bought yet more shares on March 18th.
I decided this would be my last purchase, hitting my position limt (without being defined at that time) for invested capital in this company. Afterall, I did not know how this investment will turn out (imagine it going down to DKK 100, or even lower). As the red area indicates, at the time of my last purchase I was down -30% of my total invested capital in this position. And my invested capital did increase purchase after purchase and represented a considerable amount of my overall invested capital into equities.
Sorry! The real life example would be even better with absolute DKK/Eur amounts, but for the time being I do not want to post actual amounts. So sorry for that! Imagine for yourself how your P/L would have been with fictional investments of [insert your accounting currency] … k per purchase …
The price of the shares recovered nicely (as of now) as you can see below. Currently I am thinking about trimming the position. But this result is not the lesson to be learned here.
It is mportant to imagine what could have happened (worst case: shares going to zero) and to be honest to ourselves. Is the position still within our well defined* position limits? Do we feel comfortable with the position? And would we if it goes (much) lower? Do we miss some news or risks? Is our investment thesis still intact? …
*) I plan to do a follow up post discussing position sizing and execution timing rules and define specific rules for myself. It is about time. Stay tuned.
I hope you enjoyed this article and you learned some valuable insights. What are your experiences with averaging down a position? Do you have any rules implemented?