An investor is always faced with tough questions when managing his portfolio. As an investor myself, one of the toughest questions I have faced is whether to average down or average up on existing positions. The problem arises mainly due to anchoring bias, which hooks our mind to the average purchase price we paid for a company’s shares. Subsequent considerations would sub-consciously “anchor” our minds to the purchase price to establish whether the stock is “expensive” or “cheap”. So how should we go about tackling this thorny issue?
Let us first define what the terms “average up” and “average down” mean. Average up refers to the act of purchasing shares at a higher price than the original purchase price, while average down is the converse. For the former, this would raise the investor’s average purchase price for that security, while for the latter, it would decrease it. If an investor was observing the fundamental aspects of the company and is confident that nothing negative has occurred, then obviously owning more shares at a lower price would increase his margin of safety. However, reality is usually not so simple, and there would be other considerations as well, as discussed below.
When we invest in a company and the stock price rises, we naturally feel good about it and think that the decision was “correct”. Either the outlook is more sanguine than before, or something has changed to make other investors’ perception more positive. In such a scenario, the decision seems easy to average up as the investor would feel that he was right and would also feel more positive about the company. The danger here lies in buying more shares when optimism has crept in, thereby making valuations more expensive than they previously were. If the investor were to continue to average up as the share price rises, he may lose his sense of reality and start to chase after the price. Therefore, a reality check needs to be done before an attempt to average up. The investor has to review the prospects and valuation and to see if the shares continue to provide good value.
In the case of averaging down, this is admittedly tougher to put into practice as the investor may suspect that something is wrong when he sees the share price declining. However, if the investor has assessed the company’s prospects and financials and continues to see the stock as a bargain, averaging down would be a wise decision. The important thing is also to ensure cash is always available, as there may be an opportunity to buy shares even more cheaply.
Ultimately, both methods can be utilised, but it would depend on the investor’s assessment of the company’s prospects and whether the shares offer good value and a margin of safety.
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