How To Invest

When should you average down and when should you cut your losses?

Averaging down is a popular investment strategy involving buying more shares at a lower price than your initial purchase price. Many investors use this technique to reduce the average cost of shares in a portfolio. However, averaging down can also lead to significant losses if the stock price drops. Therefore, investors must be careful when considering this strategy.

Warren Buffett, one of the most successful investors in the world once said: ‘When hamburgers go down in price, we sing the Hallelujah Chorus.’

At the same time, Peter Lynch, another legendary investor, warns that: ‘Selling your winners and holding your losers is like cutting the flowers and watering the weeds.’

These two quotes highlight the importance of knowing when to average down and when to cut your losses. Averaging down can be an effective strategy if you believe that the stock’s current price does not reflect its true value. However, this strategy should not be used blindly, as it can lead to significant losses if the stock’s fundamentals do not improve.

This article will explore when it may be appropriate to use the averaging down strategy and when it may be best to cut your losses.

When to average down

Proven business model and track record of success

When considering averaging down, it can be a viable strategy for investors if a company has a proven business model and a long history of success. These companies have demonstrated their ability to adapt to changing market conditions and have a track record of weathering economic downturns and adapting to changing market conditions. Therefore, investors will have greater confidence that the company will likely recover from short-term setbacks.

One example is Coca-Cola, a dividend aristocrat. As a leading brand in the beverage industry, Coca-Cola has demonstrated its ability to innovate and adapt to changing consumer preferences. The company has been in business for over 130 years and has consistently delivered value to shareholders over the long term. If Coca-Cola’s stock price were to drop due to temporary market conditions, an investor might consider averaging down if they believe the company’s underlying fundamentals remain strong.

Similarly, Apple Inc. has a proven business model and many decades of success. Despite experiencing major price drops from time to time, Apple has consistently bounced back and delivered strong returns for investors. With a market capitalization of over US$2 trillion, the company has a strong financial position and a loyal customer base. 

Event-driven price declines

If a stock price decline is event-driven, such as a product recall or negative news story, averaging down may be a viable strategy if investors believe the event is a one-time occurrence and the company’s long-term prospects remain strong. Investors can reduce the average cost per share of their investment by averaging down, increasing their potential for profit when the stock price rebounds.

One example of a company that experienced an event-driven price decline is Johnson & Johnson (J&J) in 2019. The company faced negative publicity after reports emerged that its talc-based products contained asbestos, which led to several lawsuits against the company. As a result, J&J’s stock price declined by around 10% in just a few days. However, the company’s long-term prospects remained strong, as it has a diversified portfolio of products and a strong financial position. Therefore, investors who believed in the company’s long-term prospects may have considered averaging down on J&J’s stock during the price decline.

When to cut your losses

Knowing when to cut your losses is just as important as knowing when to average down. When deciding whether to cut your losses, paying close attention to the company’s fundamentals is crucial.

For example, if a company’s earnings reports consistently disappoint for multiple quarters, its debt levels are increasing, or its management is not transparent, this could indicate that its underlying fundamentals are deteriorating. In such scenarios, cutting your losses and exploring alternative investment opportunities would be prudent.

Another factor to consider when deciding whether to cut your losses is to assess the potential impact of external factors or events that could negatively impact the company’s long-term prospects.

For example, if a recession hits and the company’s products or services are highly discretionary, it will likely eventually recover to its former glory days after the recession. However, suppose an industry disruption is on the horizon, such as the emergence of a new technology that could make the company’s products or services obsolete or a regulatory event that has caused long-term damage to the company’s reputation. In that case, it may be better for investors to cut their losses and look for other investment opportunities.

Ultimately, cutting your losses on a stock requires careful analysis and a willingness to take a short-term loss to avoid a larger loss in the long run. By monitoring the company’s fundamentals and external factors that could impact its prospects, investors can make informed decisions about when to sell a stock.

Considerations for averaging down

One of the most important tips to remember when averaging down is to limit the number of times you will average down on a particular stock. Continuously buying more shares can increase your risk exposure, especially if the stock’s underlying fundamentals are deteriorating.

Having a maximum portfolio allocation percentage for any position is important. This means you should avoid putting too much of your portfolio at risk on a single investment. For example, let’s assume you have set a maximum portfolio allocation of 10% for each individual position, and you’ve already invested your entire allocation in a specific stock. In such a scenario, it is essential to stick to your rule and not average down any further. By doing so, you can mitigate excessive risk and prevent overexposure of a significant portion of your portfolio to a single stock.

The fifth perspective 

Utilizing the averaging down strategy has the potential to reduce the average cost per share of a stock and potentially enhance returns. However, exercising prudence is vital as it can lead to significant losses if the stock price continues to decline. Therefore, carefully assessing the risks and rewards associated with averaging down is crucial, and knowing when to cut losses becomes equally important. Ultimately, investors should exercise caution and informed decision-making to leverage the benefits of averaging down while minimizing its potential downsides.

Wang Choon Leo, CFA

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that can connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term. Choon Leo is a CFA charterholder.

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