Don’t Average Down — I Beg You

Sometimes it works, but mostly it doesn’t

Apple stock right now, right this second, is trading at $173.07.

Is that a good price? Bad price? Fair price?

I’ll gladly admit that I have no idea!

The truth is this: NOBODY knows for sure. That goes double for people who tell you otherwise.

Now, suppose I told you that you could buy an Apple share tomorrow for $160. Would you be excited?

“It’s on sale! 8% off!” many of us will scream, racing to our brokers to pick up as many shares as we can muster.

This is just human nature: we all love a good deal.

Except there’s a big problem.

Stocks aren’t like TVs on Black Friday. And, as you’ll find out, it’s often very dangerous to think of them that way.

So, let’s rephrase the original question. What is the fair price of Apple?

The fair price of Apple is exactly what it’s trading for at the current moment in time. That single number reflects the global consensus of what people are willing to pay for it, right here, right now.

In other words, the fair price of Apple is $173.07 as of the time of writing. Nothing more, nothing less. It’s all pretty simple when you think that way.

Now, if you go out and buy Apple shares today expecting for it to go up in price, that may or may not be a good decision.

We can all have our own little hypothesis — no harm in that — but who the heck really knows where it’s going to go.

Once you’ve actually bought the shares, things get a whole lot simpler.

Why?

Well, there is a very simple feedback loop to inform you that you made the right choice when you buy Apple shares:

The price goes up!!!

Thus, it’s time to challenge the conventional wisdom — in general, no, you should NOT average down on your losing positions.

If you haven’t heard the term “averaging down” before, this refers to buying more of a stock that’s gone down in price since you first bought it. So you buy 100 shares of Apple at $160 tomorrow, then another 100 shares when it sinks further to $150 next week, on the belief that it represents “better value.” The result of doing so is a reduction in your average cost per share, which goes from an initial $160 to $155 in this case.

The value fallacy

Investing is already a hard enough game to play, but you know what makes it harder?

Our egos.

A lot of people struggle with admitting mistakes — myself included. We believe all kinds of things, like thinking we’ll be mocked by others for our errors, that we’ll lose the respect of our peers, and that we’ll even come to dislike ourselves.

And when we make big, concentrated bets that put our money on the line, it is never harder to admit we’re wrong.

If we think Apple looks just grand at $160, well, by golly, it’s an absolute steal at $150. How about $140? Back up the truck, Ellen! We’re going all in!

Now keep on going with that logic. Do you see the problem here?

More money, more problems

The big problem with buying more of a stock that’s fallen in value is quite simple, and it’s this:

There is a VERY high likelihood that you’re doubling down on your mistakes.

Now, I can’t say that with absolute certainty, of course. Every investment is different.

Yes, some stocks will fall a bit, then bounce right back, and then go soaring way past your original cost. That would be the absolute best-case scenario, and it’s the one that people stuck in losing stocks nearly always cling to (speaking from observations as well as personal experience here).

If you’re buying Apple hoping it goes up in price, and it doesn’t, well…I’m sorry to say it, but…you’re wrong.

Maybe not tomorrow, maybe not forever, but right now, you’re wrong.

When I invest, I want to maximize my gains, not my mistakes.

I know you agree with that logically — who wouldn’t? — but ask yourself, is that how you’re investing?

The only case study you’ll ever need to see

The best way to appreciate the risks of averaging down is to see what happens when it goes…poorly.

Here in Canada, we have this well-known company called Blackberry, which was an absolute stock market darling back in the early 2000’s. We can all think back fondly to those bulletproof phones and smile.

Say you bought some Blackberry stock on the blue arrow, below, heading into 2008. That would have been a fine investment for a short time, and you’d be sitting on a decent gain. You’d be feeling a lot of love for the company, and the product, once you were 30% or 40% up on your position. Who wouldn’t?

But, alas, the good times didn’t last!

The stock price peaked, and then started falling. The newspapers kept talking about some “financial crisis.” Your gain quickly disappeared. Your cost of ~$110 started to look “high,” so you bought some more shares, just below $100, at the first red arrow below.

Nice. More shares, for less. What’s not to like!?

Your unshakeable convictions in Blackberry remained strong over the next few years, and you kept doubling down, buying more shares at each of the red arrows below.

All those share purchases at lower and lower prices brought your average cost down from an initial $110 to about $66 — nearly half!

It would seem there’s much to celebrate.

Except for one little thing: Blackberry is now trading at $9, meaning you have absolutely obliterated your capital. The stock never stopped falling.

You have a 77% loss on your hands.

Yikes. Bye-bye, retirement.

The takeaways

I know, I know, I just showed you the worst-case scenario. How cruel and unusual of me.

But you must realize, when you average down, THAT is the risk you’re taking. Nobody should ever experience such a disaster!

Yes, some of the world’s smartest investors will average down from time-to-time. They’re backed by armies of highly paid investment professionals, with big fancy Excel models, that take ten minutes to open.

And while they may be totally aware of the risks, they’ll often get it wrong too. I’ve worked in firms with 90%+ losses on some of their positions. We’re talking hundreds of millions of dollars gone. It’s not pretty.

So, what is one to do instead?

In my view, as well as that of many respected growth investors, you’re better off averaging up. Add to your winners. Compound the stocks you’re actually getting right.

It certainly feels unconventional and counterintuitive, I will absolutely admit that.

The only way to beat the market is to do something different than everybody else.