I’m not going to pretend I’m an expert here. Just giving my two cents worth based on what has worked for me and what hasn’t.
The perennial question that pops up every time I trade is this: Should I average down or cut loss?
I once knew a good trader. He used to be the Treasury Head of an investment bank in London and he also claims that he’s a savant. He passed away last year at the age of 96. So, I suppose, he’s seen a lot and should know a lot. He told me that if I was to be a better investor, I should NEVER EVER average down. According to him, all the people he knew who averaged down became bankrupt. Now that’s a stark a warning.
I also know a financial advisor who advised me to never average down. He said I should set a stop loss of, say, 10% and ruthlessly cut my loss when the 10% stop loss is hit. He said, I should average up instead. According to him, he made his millions by sticking to that one strategy. My financial advisor friend says that if I average down, I am tying my money to a losing stock. By averaging up, I’m positioning my portfolio with the winners.
It sounded good to me. The only question in my mind these past few weeks though is that I’m hearing my financial advisor friend singing a different tune.
You see, this year, he invested a significant portion of his equity portfolio in one nickel mining stock that he said would be a sure winner. That was the time when Indonesia placed a ban on its ore exports and the prices of the metal skyrocketed. I guess he did his research, met with the owners, and was convinced it was an excellent buy, a sure deal. Rumors were going around that the mining company was about to announce a private placement deal that would be priced 10 times higher than the current price it was doing in the stock market.
Unfortunately, the price of certain commodities, including nickel, started falling just a few months after my friend bought the stock. His nickel mining stock totally cratered, losing 75 percent of its value in just a few weeks.
I was wondering what he would do. Would he admit he made a mistake and cut his loss, just as he advised me to do in the past? Surprisingly however, I learned that he has actually been averaging down. Little by little, but still averaging down.
So what’s happening? Is this a special situation where the NEVER average down rule doesn’t apply? Is this a new principle I should be learning? Or is my financial advisor friend just emotionally overwhelmed with his tragic loss that he no longer hears the voice of his own reasoning? I haven’t actually asked him these questions though. I don’t want to rub salt on his wound right now.
Many an day trader I’ve met had turned into a “long term” investor because he didn’t cut his loss. His favorite stock became a STUCK. Many a broker I’ve known became plain BROKE from buying stocks at increasingly lower prices until he finally ran out of ammo.
I think fund managers can and should actually average down, especially those with huge funds that they need to deploy. They can’t buy all at one time because they’ll be driving the price up all by themselves. And so, they need to keep their buying as low key as they can. Buying in small batches over a certain stretch of time, buying on dips, averaging down if the market permits, until they have fully invested their target amount. But for us individual investors who couldn’t make a ripple in the market even if we sold our house and went all in on one stock, averaging down seems like a bad idea – most of the time.
Of course, cutting loss also has its pain. There were times when I got whipsawed so bad, my husband said I looked like I just got back from a terrible automobile accident. Eyes in a blank stare, arms paralyzed, in absolute unbelieving shock at what actually happened. Imagine holding on to a stock for years, going through its ups and downs, dreaming about it at night, studying its every move, and one day you get scared by a drastic dip, you panic and hit sell, and that’s the time it then goes soaring to high heavens. (And you’re out!!!)
So the question continues to haunt me. Do I average down or average up? Do I cut my loss? Somebody help me.