Two words, ‘average’ and ‘down’. It sounds a strategy lacking oomph. But an averaging down trading strategy can make a meaningful profit for you short and long term.
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.