But how does it work with the irrational trading biases we carry around inside our heads? These are two danger biases all traders need to fight against: anchoring and loss aversion.
First, a basic understanding of what averaging down is: the averaging down trading strategy is when you buy more of an asset – forex, commodities, shares, even classic cars and art – if the price continues to fall but you believe this means you’re buying at a lower price than the asset is worth and the price will bounce back.
The hope is that ‘averaging down’ lowers your overall costs, reducing the price at which investment returns to profit when the price bounces back.
Cognitively savvy or stupid?
Let’s say you buy into XYZ stock, a popular blue-chip utility stock, at £20 per share. You snap up 10 shares worth £200. The government announces it wants energy companies to cap prices and introduce an easy-to-understand basic tariff available to all.
Profits look a bit harder to make and the share price of XYZ utility company drops from £20 to £18. But the long-term prospects are solid enough so you snap up 10 more shares. This time your 20 shares have cost you £190, not the £200 they cost earlier.
A further drop in price enables you to snap up ten more share but at £16 a share, costing £160. Your average purchase price is now £18 a share
All straightforward enough. This is ‘averaging down’ at work and means you have successfully trimmed the average cost of your share purchase overall. It also means your stock has less to climb to show a profit. In this case, if it climbs above £18, you make money. The stock does not have to get back to your original purchase price of £20.
Buy and sell points
Let’s look at it from an initial cognitive trading angle. Both anchoring and loss aversion biases play a big part in when traders buy and sell. For example, buying in at a certain point is often the ‘anchor’ level. It is the level at which you measure your gains or losses relative to the price you originally paid.
In your mind’s eye, all deviations, up or down, from this figure are meaningful. However, this view may be at the expense of the longer time frame when the broader external economy was fundamentally better, or worse. Or when debt cost less, or more.
If you focus just on that anchor point without considering other factors, it is a bias, pure and simple.
Anchoring bias and loss aversion bias
Anchoring bias is particularly critical for traders looking at stocks or sectors they are not familiar with. They are looking at these areas for the first time. Their reference points are few. All options, price comparisons and price shifts are measured from the point of when they first bought their assets.
Loss aversion can exert huge pressure not to sell, or to cling onto a stock that is falling in value. In an averaging down context, loss aversion may imply a belief that the stock or trade long-term will improve even when there is no rational reason to believe this.
Your loss aversion bias might convince your to continue buying stock – to average down – when there is no rational reason to do so. Selling up and taking the loss on the chin might be the better option
Anchoring bias may stop you selling until the price recovers to your initial purchase price. It misses the point of averaging down.
Focusing on different prices
The traditional anchoring bias involves making your anchor point the initial £20 purchase price. You might hang on for a return to that price when it is never going to happen. If your anchor is the £20 initially paid and the price never rises above £20, you will not have sold whereas you could have sold for a profit at anything above £18 – the average price you paid for the stock.
If, on the other hand, your focus price is the last price paid, £16, you might sell too early when the price rises above £16, say £16.10. You will have recovered money on the last ten shares bought but lost money on the other 20, giving you an overall loss of £379.
If you can avoid your biases and successfully use the averaging down trading strategy, you would have sold at £18.10 and made a small profit of £3 of your total trades. At £18.50 you would have made a profit of £15, or just short of 2.8% of your total investment.
Averaging down requires you to forget all your purchase prices and focus on the average purchase price at which you can profitably close your position.
Give up that gut ‘anchor’ feeling
The averaging down trading strategy means you are adding to a losing position but reducing the price at which a bounce-back returns a profit. This works well for a long-term investor, when the share price has time to recover. For day traders, it would require a highly volatile asset that had large falls and rises in a single day.
Remember, disciplined trading relies upon the protection of losses. It is about mindful judgements, not ‘gut feelings’ or hope. Averaging down is not always the best trading strategy.
Think of it from another angle: while you’re diverting energy (and money) to a downward moving asset, you are potentially wasting opportunities with trades going in the other direction, such as ‘momentum’ or ‘trend’ stocks.
The trader’s priority is always to make money. While averaging down can work effectively for traders in certain condition, such as when the market is about to turn, averaging down for the wrong reasons can be bad news for your trading health.
Loss aversion bias
The averaging down trading strategy can be ruinous if you suffer from loss aversion bias. At its heart, loss aversion is an intense unwillingness to sell loss-making stocks or trades even when they’ve turned rancid.
Sometimes traders need to sell at a loss and put it down to experience. Loss version bias stops you taking that sensible, if painful, decision.
When loss aversion bias is aligned to the averaging down trading strategy – buying stocks that are losing value in hope they will turn around – it’s the perfect toxic relationship: an unwillingness to move on and get over it, twinned to a lack of market interest.
If you buy more and more stock as the price falls, because you refuse to believe the evidence that this stock was fundamentally overvalued and has turned sour, you are not averaging down – you are throwing away good money after bad.
The averaging down trading strategy does work
To be clear, buying or trading stocks when they are beaten down in price can work. Billionaire investor Warren Buffet has made a career and a fowrtune from buying out-of-favour ‘value’ stocks.
But Buffet has done so mainly in the right circumstances (though he’s humble enough to admit mistakes also). That is, when the stock is not threatened by technological obsolescence, litigation threats, mismanagement – or any number of reasons that indicate a stock or trade is priced low because it’s a blazingly bad buy.
Averaging down works when the fundamentals of a company are sound and it is undervalued on a range of basic valuation metrics.
Going the other way – Averaging up
Averaging up is the opposite path. Averaging up means you buy more shares as the share price climbs. Unless there is a rational move not to buy more shares, then a share price is likely to climb further.
Often averaging up means you buy fewer shares as the price climbs, or momentum slows. This is sensible risk-averse strategy and has been proved effective long-term.
Some claim averaging up is less risky than averaging down as you are buying into stock with positive market sentiment driving its share price – and the market is always looking ahead, however short term that view is.
So, two very different approaches but both rely on similar, if opposed, tactics.
Averaging down trading strategy – consider:
- Technical traders – they operate on rationality in decision making and use averaging down within stop loss levels which typically protect them from a sinking share price
- If you think there is room for averaging down in your medium or long-term portfolio, think about applying the strategy across a range of stocks – preferably blue chips with manageable debt levels and decent management – or sectors you have long-term confidence in so your risk is spread
- Averaging down not only has strong links with anchoring and loss aversion biases but also with the Martingale effect. The Martingale bias sees investors doubling their investment in a losing trade in a desperate attempt to ‘break even’ and recover. It can be ruinous
- If company ‘insider’ management also sells their stock, it’s probably over. Get out