Averaging up and the hot hand fallacy

Originating from US basketball, the concept of having a hot hand hinges on the belief that the chance of hitting a basket is greater following a hit than a miss. In investing, it means believing you have a greater chance of success after completing a series of successful trades.

When applied to stock market investment, a hot hand investor would expect to be rewarded for a new investment decision based principally on the fact that their previous investment was profitable. As a trader, you might feel you are ‘on a roll’, however, studies show the hot hand is a misperception of chance in random sequences.

The reality is that there is no positive correlation between successive shots in basketball and the success of your next trade on the markets has no relation to the success of your most recent trades. You do not have a hot hand.

Pyramiding is a way of increasing ownership of a stock as prices rise; Photo credit: Shutterstock

Averaging up, or pyramiding

Hot Hand thinking can often be linked with what is termed averaging up. Often referred to as ‘pyramiding’ this is when, after buying shares in a company, you buy some more as the price gets higher.

The hot hand bias may be persuading you to see only the upside, even though the share price has already risen significantly. Rather than buying low and selling high, by averaging up you are continuing to buy while prices are no longer ‘cheap’.

This strategy is not necessarily flawed, though, as the stock in question may indeed continue to rise significantly with the investor making a greater profit. But make your choice to continue investing based on research not your hot hand.

Similarly, if you are going short on asset you can continue to increase your positon as the price falls, but do so the basis of serious analysis of the reasons and likely continued fall in that asset’s price. Don’t believe it must continue to fall just because you picked it.

Identifying growth potential

What is an accurate definition of ‘cheap’ anyway? Is it in relation to historic valuations, or sector comparisons? What if the company in question has completely changed its business model or been a major disruptor in its sector? Do historic valuations always offer meaningful insight?

Just because a share price has doubled in value, does that mean it is time to take profit? Many companies (particularly smaller cap) have the potential to double their share price and then double it again…..and keep going. 

For instance, in 2016 WeightWatchers saw its share price more than quadruple, with subscriber numbers boosted by the support of celebrity investor Oprah Winfrey. 

Another company to quadruple its share prices was Esperion Therapeutics, a developer of drugs to treat cardiovascular disease. Positive drug trials in the US resulted in a soaring share price. 

Benefits of averaging up

The advantage of averaging up in these instances, is that the investor is still in the game as the share price rises. As long as research and logic are the guiding principles and not the hot hand theory, averaging up can be a useful tool for traders.

Going back to the pyramid concept, the initial shares purchase is the wide base, then the pyramid gets narrower with subsequent buys. The ‘pyramid’ term relates to the fact that each time you buy more shares, you are buying a smaller number for same size stake.

Averaging up in this fashion ensures that your average cost doesn’t run up too fast, while still boosting your position in a potential winner. Essentially, you start a position and buy more in decreasing increments until after four or five buys, you have your full position size.

Let’s say you’d like to own 500 shares of ABC & Co but rather than buy the whole 500 in one go and hold them; you purchase 300 shares and add to them as they show a profit until you reach your optimum 500 shares. If the initial trade doesn’t work out, risk has been limited as you’ve not bought a full position size. There is less exposure to a falling stock.

Successful investing is a combination of diligent research and good timing. Photo credit: Shutterstock

It is all about timing

The big decision for every trader is when to average up.

For instance, it could be when the share price has risen by a specific percentage above the initial purchase price – a trigger point. Depending on your trading timeframe, this could be, say, 2% or 10% or 25%.

Alternatively, investors may adhere to specific chart systems, either for individual shares or assets, or cumulative market-based charts, such as those identifying the number of stocks making new highs on a specific index or on a specific exchange.

Whatever the methodology, it is important that the confidence in an asset’s upward trend or growth prospects are well founded and based on good fundamental or technical analysis.

Sentiment should not come into it, investors averaging up need to stress test their decision-making process ensuring it is rational with no psychological bias. 

There is often a fixation in watching the ‘escaping winner’. Arguably, averaging up allows your brain to rule your heart. The appeal to some investors is that it provides a degree of risk control.

The downside

Averaging up is not for everyone or for all occasions. There are disadvantages. For instance, transactions costs are higher due to higher frequency of trading. There will be more commission to pay on, say, four trades than just one. 

Not only do investors need to set aside cash for follow up share purchases, they will need to buy at a higher purchase price.

By the time you are fully invested, you may have missed out on higher returns than if you had been fully invested from the outset. There is always the trade-off between risk control and higher costs.

Another consideration is that the market could turn violently with indiscriminate sell-offs the order of the day. If the share price of a stock plunges, those additional shares bought prior to the price collapse would likely wipe out any profits from previous trades.

If momentum is on the side of the investor, then averaging up can be beneficial but as with most trading strategies, there are no guarantees

The share price of well-established names do not always rebound if the fundamentals are bad. Credit: Shutterstock

Good fundamentals

It may be that the market has under-valued a stock and that the fundamentals of the business - its balance sheet, order book and management team are either in good shape or showing signs of improvement.

It is important that you do your own research if you are thinking of buying more shares while also understanding why institutional investors are selling out of the stock.

What signals are there that the fall in price is temporary or an undervaluation, rather than an indication of a deep-seated problem within the business?

As with averaging up, the focus should be on making rational decisions based on research, the market situation and according to a trading plan. Decisions should not be influenced by psychology and trading biases. You haven’t got a hot hand. You never have had.