Why averaging down is a poor strategy
What we can do instead
I’ve always been a proponent on averaging down on my holdings that have dropped in price.
This is no longer the case.
Over the years, I’ve found this to be a poor strategy.
What if the share price continues falling, taking years to recover?
Would you have the guts to hold on without selling?
Now you may say “ Stock price isn’t everything.”
Yes, it isn’t.
But…
Stock price follows business fundamentals.
What I’m doing with my stock that has fallen in price
I bought Lululemon (LULU) recently at $358.
Since then, the share price of the company has fallen >10%.
The common advice would’ve been “If there’s no change in the company’s fundamentals, average down on the stock!”
While this is a sound strategy, there’s just one problem: Opportunity cost of capital
Capital being tied up in a losing position.
This is why I am not adding more shares to my existing position, even after identifying multiple buy levels.
The company hasn’t yet proven itself in terms of share price performance.
Yes, the focus should be on fundamentals instead of share price.
But how many of us have the patience to wait years before seeing our stock turn green (even if the fundamentals are intact)?
The other scenario is “What if we’re wrong about the stock, and it continues to go down as we average down?”
By averaging down, we’re compounding our losses.
Takeaways
Psychologically, averaging up feels more difficult than averaging down.
That’s because we are anchoring on the price we previously paid for the stock.
If we bought a stock for $10 previously, it’s hard to bring ourselves to pay $20 for it the next time.
What we fail to account for: the intrinsic value of high quality companies increase over time.
This increase in intrinsic value justifies the increase in stock price.
Employers give raises to employees who have “proven” themselves to be capable.
Likewise, we can use the increase in share price as a sign that the company has “proven” themselves.
I hope you enjoyed reading this piece as much as I did writing it.
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