Wednesday, July 27, 2011

Buying Stocks When The Price Goes Down: Big Mistake?

Elvis Picardo
Contact | Author Bio
• Averaging down involves buying more of a stock when its price drops.
• This strategy works when a stock is truly undervalued.
• Some stocks deserve a price drop and may continue to decline, rather than rebound.

The strategy of "averaging down", as the term implies, involves investing additional amounts in a financial instrument or asset if it declines significantly in price after the original investment is made. It's true that this action brings down the average cost of the instrument or asset, but will it lead to great returns or just to a larger share of a losing investment? Read on to find out.

Tutorial: The World's Greatest Investors

Conflicting Opinions
There is radical difference of opinion among investors and traders about the viability of the averaging down strategy. Proponents of the strategy view averaging down as a cost-effective approach to wealth accumulation; opponents view it as a recipe for disaster.

The strategy is often favored by investors who have a long-term investment horizon and a contrarian approach to investing. A contrarian approach refers to a style of investing that is against, or contrary, to the prevailing investment trend. (Learn how these investors profit from market fear in Buy When There's Blood In The Streets.)

For example, suppose that a long-term investor holds Widget Co. stock in his or her portfolio and believes that the outlook for Widget Co. is positive. This investor may be inclined to view a sharp decline in the stock as a buying opportunity, and probably also has the contrarian view that others are being unduly pessimistic about Widget Co.'s long-term prospects. Such investors justify their bargain-hunting by viewing a stock that has declined in price as being available at a discount to its intrinsic or fundamental value. "If you liked the stock at $50, you should love it at $40" is a mantra often quoted by these investors. (To learn about the downside to this strategy, read Value Traps: Bargain Hunters Beware!)

On the other side of the coin are the investors and traders who generally have shorter-term investment horizons and view a stock decline as a portent of things to come. These investors are also likely to espouse trading in the direction of the prevailing trend, rather than against it. They may view buying into a stock decline as akin to trying to "catch a falling knife." Such investors and traders are more likely to rely on technical indicators, such as price momentum, to justify their investing actions. Using the example of Widget Co., a short-term trader who initially bought the stock at $50 may have a stop-loss on this trade at $45. If the stock trades below $45, the trader will sell the position in Widget Co. and crystallize the loss. Short-term traders generally do not believe in averaging their positions down, as they see this as throwing good money after bad.

Advantages of Averaging Down
The main advantage of averaging down is that an investor can bring down the average cost of a stock holding quite substantially. Assuming the stock turns around, this ensures a lower breakeven point for the stock position, and higher gains in dollar terms than would have been the case if the position was not averaged down.

In the previous example of Widget Co., by averaging down through the purchase of an additional 100 shares at $40, the investor brings down the breakeven point (or average price) of the position to $45. If Widget Co. stock trades at $49 in another six months, the investor now has a potential gain of $800 (despite the fact that the stock is still trading below the initial entry price of $50).

If Widget Co. continues to rise and advances to $55, the potential gains would be $2,000. By averaging down, the investor has effectively "doubled up" the Widget Co. position. Had the investor not averaged down when the stock declined to $40, the potential gain on the position (when the stock is at $55) would amount to only $500.

Disadvantages of Averaging Down
Averaging down or doubling up works well when the stock eventually rebounds because it has the effect of magnifying gains, but if the stock continues to decline, losses are also magnified. In such cases, the investor may rue the decision to average down rather than either exiting the position or failing to add to the initial holding.

Investors must therefore take the utmost care to correctly assess the risk profile of the stock being averaged down. While this is no easy feat at the best of times, it becomes an even more difficult task during frenzied bear markets such as that of 2008, when household names such as Fannie Mae, Freddie Mac, AIG and Lehman Brothers lost most of their market capitalization in a matter of months. (To learn more, read Fannie Mae, Freddie Mac And The Credit Crisis Of 2008.)

Another drawback of averaging down is that it may result in a higher-than-desired weighting of a stock or sector in an investment portfolio. As an example, consider the case of an investor who had a 25% weighting of U.S. bank stocks in a portfolio at the beginning of 2008. If the investor averaged down his or her bank holdings after the precipitous decline in most bank stocks that year so that these stocks made up 35% of the investor's total portfolio, this proportion may represent a higher degree of exposure to bank stocks than that desired. At any rate, it certainly puts the investor at much higher risk. (To learn more, read A Guide To Portfolio Construction.)

Practical Applications
Some of the world's most astute investors, including Warren Buffett, have successfully used the averaging down strategy over the years. While the pockets of the average investor are nowhere near as deep as deep as Buffett's, averaging down can still be a viable strategy, albeit with a few caveats:
• Averaging down should be done on a selective basis for specific stocks, rather than as a catch-all strategy for every stock in a portfolio. This strategy is best restricted to high-quality, blue-chip stocks where the risk of corporate bankruptcy is low. Blue chips that satisfy stringent criteria - which include a long-term track record, strong competitive position, very low or no debt, stable business, solid cash flows, and sound management - may be suitable candidates for averaging down.

• Before averaging down a position, the company's fundamentals should be thoroughly assessed. The investor should ascertain whether a significant decline in a stock is only a temporary phenomenon, or a symptom of a deeper malaise. At a minimum, factors that need to be assessed are the company's competitive position, long-term earnings outlook, business stability and capital structure. 

• The strategy may be particularly suited to times when there is an inordinate amount of fear and panic in the markets, because panic liquidation may result in high-quality stocks becoming available at compelling valuations. For example, some of the biggest technology stocks were trading at bargain-basement levels in the summer of 2002, while U.S. and international bank stocks were on sale in the second half of 2008. The key, of course, is exercising prudent judgment in picking the stocks that are best positioned to survive the shakeout.
The Bottom Line
Averaging down is a viable investment strategy for stocks, mutual funds and exchange-traded funds. However, due care must be exercised in deciding which positions to average down. The strategy is best restricted to blue chips that satisfy stringent selection criteria such as a long-term track record, minimal debt and solid cash flows. 

by Elvis Picardo