Thoughts on Averaging Down 📉
Inspired Entirely by John Hempton
Recently I stumbled across John Hempton’s post: “When to Average Down”. After consuming the thought-provoking material, I felt compelled to 1) share what I had just learned with others and 2) write about it. Do I think I am going to add any valet to the conversation which is not already been accomplished by John? Probably not, but I hope to provide some entertainment that you can enjoy and thus remember to revisit the next time you think about averaging down yourself.
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For the sake of keeping this short and sweet, it came to my attention that a long lengthy post telling the story about how I almost blew myself up because I decided to average down wasn’t necessary. All you need to know is this: I bought a big position, it went down, I doubled down with options, and cut the position well in half a few days later because I was having trouble sleeping at night. The bad news is I kept the option which promptly lost almost 80% of its value because I like to try and be smart rather than avoid being stupid (more on that in another post) but the good news is if I stuck with the initial average down I would have a SEVERE permeant capital loss.
Walking the tightrope of being concentrated and taking the advice, “No one ever got rich off their 8th best idea” too far can have some serious consequences. It was a good lesson in humility but I digress.
The question of when to average down is simple yet complicated. If you average down and the name becomes the winner you feel like superman, if it goes the other way you might blow up. This needs to get addressed before we go any further. Survival is more important than returns. You can not win the game if you are not playing and thus survival is priority one. Always. Full stop.
After acknowledging this there are two bumpers we can put on ourselves as investors that can keep up from becoming our own worst enemy and they come much more with a simple preparation in process. They are three things, all of which I have hijacked from John’s post that which I very much agree with,
1) Go into an investment with a set limit on how much you can fully allocate to one idea. For example, if my limit is 10%, my intial postion can be 7% and if I wish to average down should the opportunity presents itself, I can only add 3% more.
2) Stay away from averaging down into levered situations and technical obsolete businesses. Just stay away. When things goes wrong they are wrong fast and they don’t tend to improve. John uses the examples of when Bill Miller had his large blow-up in ’08 with the bank stocks and his averaging down into Kodak after it became clear the business was doomed.
3) You’re not allowed to add more until at least 6 months have passed. This is more just a “sit down and let some time play out before you make your next move:” This is something he talks about but would have worked wonders for me in my given investment. Sometimes it’s easy t feel rushed when we see lower prices, the feeling of “get it while it’s down” can be a strong one. An investor only knows a company after he has owned it for a little while and giving it at least 2 quarters before making another decision is prudent.
Averaging down is one of those thoughts and processes that can come across as redundant. It’s easy to fall into the trap of adding more to an idea without taking a second to stop and think if adding more here is smart. I mean you wouldn’t have bought the stock if you thought you were wrong going in and hey “If you liked it at $20 you must love it at $10” is easy to give into. There is a possibility you might be right but there is also a non-0 % chance you’re wrong. Taking the time to really think through the decision to average down is a perfect example of what it means to try and avoid stupidity rather than trying to look smart. It might slow you down. It might mean you leave money on the table. But it will keep you around to invest another day. It might not be sexy but it’s essential for playing the “loser’s game”.
Thank you again to John who authored the original post, I can say you have saved at least one investor.
Peace and Love,
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Please be advised, Wall St Gunslinger is not an investment advisor and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investment decisions. Thank you.