Never Average Down Falling Stock

Never Average Down

Never Average Down As A Stock Declines

By Dr. Winton Felt

Never average down.  When a stock falls significantly below your purchase price, it is foolish to buy more.  The stock is clearly not behaving the way you anticipated.  When a person tends to his garden, he pulls out the weeds and feeds the flowers.  Would it make any sense at all to pull the flowers and feed the weeds?  Strangely enough, many investors will sell a winning position to lock in a profit because they are afraid the stock will decline and that profit will evaporate.  Instead of selling, they should let the stock run as long as it “wants” to and sell only if they get a sell signal.. 

They will not sell a stock that has declined because that would lock in the loss.  People do not like to admit that they were wrong about a choice once they have made it.  Therefore, rather than conclude that they made a bad choice, they convince themselves that the choice was right and that since the stock has declined it is a better deal now than it was originally.  In a state of denial, they buy more of the stock that declined.

If the investor bought right at the line of support, the stock should have risen rather than decline.  Expert traders often buy at a line of support because that helps them minimize risk.  If the stock falls to a close only 3% below that line of support, the experienced trader knows something is wrong and can sell with minimal loss.  However, the amateur denies he made a mistake and buys more.  If the stock declines, that is certainly not a buy signal, it is a sell signal.  The stock was bought on a certain premise.  If that premise proves to be wrong, there is no longer a valid reason for maintaining the position.

If you get a margin call, you have obviously been in the stock too long.  A margin call occurs when the stock has had a significant decline.  If your reasoning was sound when you purchased, that should not happen.  Never meet a margin call.  Why throw good money after bad?  Save your cash for something that looks more promising rather than put it into something that has already started to fail. 

It is far better to buy more as a stock rises (average up), because it is behaving the way you anticipated.  Traders at prefer to average up rather than average down.  The fact that a stock is moving in the right direction after its purchase is evidence that the thinking behind that purchase was sound.  It is an indication that the right decision was made.  Our own traders put additional money into their more successful ventures, not into their failures.  Averaging up rather than averaging down is our preferred procedure if we average into a position.  A stock that has already started to rise above its support, presents far less risk than a stock that already started to decline below its support.

Hanging onto losers is based on the faulty premise that a declining stock will eventually recover.  LA Gear did not recover.  JDS Uniphase did not return to its previous levels.  A lot of stocks never recover.  There is another problem.  While waiting for a stock to recover, which can take years, many opportunities to accumulate profits in other stocks will be lost.  The money that might be used to make those profits cannot be so used if it is all tied up in losers.

Look at it this way.  If you keep pulling the flowers out of your garden and you keep feeding the weeds, what will be the eventual outcome?  You will have a garden of weeds.  Keep hanging onto losers because you do not want to lock in a loss, and you will eventually have a portfolio of losers.  You will no longer be an investor because your money will be “frozen” in a non-performing portfolio, perhaps for years, while you wait for your stocks to recover.

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