Should you buy more shares when the price is falling?
Most of us know what it feels like to buy a share that drops sharply in price shortly afterwards. Deciding what to do next can be surprisingly difficult – not least because it’s hard to admit that we may have made a mistake.
That’s why some private investors end up following a strategy called “averaging down” when their investment decisions go against them.
Averaging down involves buying more shares after they fall in price, lowering the average cost of all the shares held and thus the point at which the overall trade breaks even.
Here’s an example of how averaging down works. Say you purchase 100 shares in a company for £1 each and the price then halves to 50p. You then buy another 100 shares at 50p. To keep things simple, let’s ignore dealing costs and taxes such as stamp duty.
This means that your total holding is now 200 shares at an overall cost of £150. Your average cost is 75p per share.
Now let’s assume that the stock price then rises back to 80p. If you sell out now, you will make a 5p per share overall profit, equal to a gain of 6.7per cent.
Obviously, averaging down hasn’t done anything to fix the loss on your initial purchase – you’re still down 20 per cent on the first investment. Averaging down isn’t a magical way of undoing badly timed decisions. However, you are gaining 60% on your second purchase and you’re coming out ahead overall.
Given that taking a loss can be a blow to our pride, it’s easy to see why averaging down is a popular strategy. But is it a sensible one? Let’s take a look at the advantages and disadvantages.
Why averaging down can lead you astray
Advocates of averaging down frequently point to advice from famous investors to support their strategy.
For example, Benjamin Graham – often described as the father of value investing – argued in his book The Intelligent Investor that investors should view downturns as a chance to buy already cheap stocks at even lower levels. Walter Schloss, who studied under Graham before running his own investment firm, said: “We like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down”.
Former fund manager, Peter Lynch has said that falling prices offer investors buying chances provided that a firm has good long-term prospects. In One Up on Wall Street, Lynch argues that investors should see “a price drop as an opportunity to load up on bargains from amongst your worst performers,” and that a “price drop in a good stock is only a tragedy if you sell at that price and never buy more.”
This kind of advice makes it sound as if averaging down is an obvious principle of investing. But it’s important to bear in mind that this only works if the stock’s prospects are still sound. And the reality is that there are often good reasons for a share price drop.
The situation may have changed since your initial investment. A company or sector could be in long-term decline. New technology may make a once-vibrant industry obsolete. Overlooked problems, such as mismanagement or even fraud, might be coming to the fore.
It can be very difficult to know whether this is the case, especially since it’s easy to become emotionally attached to your favourite investment ideas. Many investors assume that the market simply doesn’t understand the merits of their stock – or even that the share price is deliberately being pushed down by short-sellers.
It’s crucial to try to avoid this mistake and recognise that other investors may be seeing something that you’ve overlooked.
Three ways averaging down can work against you
It’s also important to understand how averaging down can work against you. First, bear in mind that a stock that halves in price will need to double to regain its original level. You always need to be realistic about what kind of recovery you can expect from a share, rather than assuming it will go back to the price at which you bought.
Second, investors who have averaged down on a stock are likely to have devoted a disproportionate amount of money to it compared with their other holdings. This could unbalance their portfolios.
Third, when investors average down on a stock, they’re banking on an eventual recovery in the price. But it’s quite likely that the latter won’t pick up, at least in the short term. Buying shares that are dropping goes against the “momentum effect”: the tendency for stocks to continue trending in the same direction for several months. Ask yourself how you’ll feel if your investment continues to tick lower and lower.
All this means that there are many reasons why averaging down is frequently not a sensible strategy. Instead of staying with your winners and cutting your losers, it encourages you to do the opposite.
That doesn’t mean that you should never buy more of a share when it’s fallen in price. But it certainly shouldn’t be automatic.
Each separate decision to invest in a stock should be treated independently. Large price falls should be a reason to re-examine your initial investment decision. Often the best decision may be to sell out altogether, and avoid throwing good money after bad.
• Culled from wealth.barclays.com
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