Don’t Average Down
If you’ve been losing money on the markets, you're probably making one of several mistakes that everyone makes.
I'm currently working on a top ten list of these for the new edition of Naked Trader, out in September!
So what's the number one boob then? I reckon it has to be:
This is probably the biggest trading sin: Averaging down usually means. “I’m buying more of the crap share that I originally bought at a much higher price. It’s fallen quite a bit, but if I get some at a lower price maybe I’ll end up breaking even when the shares bounce back.”
For example: you bought shares in Terrible Prospects plc at 500p, it is now 400p and you buy the same number of TP plc again at 400p. Your effective buying price is now 450p. This means that at any price over 450p you’re making money, whereas previously your break-even was 500p. Good news, no?
No. This is a terrible strategy, as your share is going down for a reason and if it goes down some more you will make even bigger losses. And you’ve now almost doubled your position size so your losses are going to be twice the size they would have been.
Of course what you should have done is cut your losses on Terrible Prospects plc at 440p, got the hell out and moved on. This does not mean averaging down will never work, but more likely than not it won’t.
It’s far better to average up. That is, buy more of a share you’ve already bought and which is rising healthily. I don’t know how many people I’ve encountered that kept on buying something as it went down.
If a share is going down, there is probably a reason behind that. Much better always to get out totally then re-evaluate and get in back in much further down.
I have heard countless stories of averaging down. DON’T !
One from a reader: “I liked the look of Utilitywise as it came up on a momentum screen at 200p at the beginning of 2017. It dropped and then kept on dropping and instead of getting out or setting stops. Not only did I stay with it, I averaged down all the way only selling at 5p at the end losing myself £16,000. How stupid am I?”
Well, at least the reader got something for it before it went bust!
Some people will hold onto a share forever while it sinks further or even goes bust, thus affecting your ability to make the big money. Those who average down don't realise they are in the grip of confirmation bias which means they will never listen to anything negative about the share going down and will stick to it like a loyal football fan.
Investors who only ever sell things that have made a profit and never sell anything that's made a loss will end up making little profit over time.
The only way to get out of confirmation bias et al is to sell everything you have that is down by more than 35% or more. Don't even look and see what it is. You'll feel much better after you dumped the losers and you'll have lots of cash ready for new buys - and this time, have stop losses!
Lesson: Never ever keep buying more of a loser as it goes down. Get out first, ask questions later.