The Zurich Axioms By Max Gunther
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Never try to save a bad investment by averaging down
The technique known as ‘averaging down’ or ‘averaging losses’ is one of the investment world’s most alluring traps. It is like those fail-safe, sure-fire, double-guaranteed systems for beating a roulette wheel, which are hawked in the streets and bars of Las Vegas and Atlantic City. When you first examine such a system it seems unassailably logical. “Why, yes, this really would work, wouldn’t it?” you say, wide-eyed with wonder. The loss-averaging technique is like the roulette systems too, in that it will work sometimes – when the player is lucky. That, of course, adds to its allure. But you must be careful not to let it beguile you. It is a rose with poisonous thorns.
Here’s how it is supposed to work. You buy 100 shares of Hoo Boy Compuer at $100 a share. Your cost (ignoring brokerage commissions for the sake of simplicity) is $10,000. Things go badly, and the price plunges to $50. You seem to have lost half your investment. Alas! you weep. But wait! All is not down the tubes! Your friend and neighbor, Numbsley Skullbone, who never made a dime speculating in his whole life but knows ever investment cliche by heart counsels you to improve the situation by averaging down.
What you should do, Skullbone says, is buy 100 more shares of this dog at the new bargain price, $50. You will then own 200 shares. Your total investment will have been $15,000. You average cost per share, therefore, will have dropped from $100 to $75.
Magic! By taking Numbsley Skullbone’s advice, you can make a bad situation look less bad By throwing in new money, you can make the old money look smarter!
Once you’ve averaged down in this way, Skullbone tells you, you won’t have to wait so long to get out even. You don’t have to wait till the trading price climbs back up to $100. All you have to wait for under the new circumstances is $75.
Beautiful, right?
Not exactly. All you do when you average down is to fool yourself. No matter how you squirm and wiggle, you are not going to change he fact that you did pay $100 for those original 100 shares. Buying 100 more at $50 doesn’t change he fact. Talking about the new average price of $75 may make you feel better for a while, but it doesn’t do a bit of good for your financial condition.
What the whole misguided operation may do to your financial condition, in fact, is to make it a lot worse. Hoo Boy Computer’s stock price has plummeted from $100 to $50. Presumably the market has some reasons for this sharp diminishment in its estimation of the company. What are those reasons? Study them. Maybe they are valid. Maybe Hoo Boy faces a lot of years in which its earnings are going to be poor. Maybe the stock is a good investment to stay away from the time being. If that is so, why on earth are you buying more of it?
In any situation where you are tempted to average down your costs, ask yourself this: “Would I buy Hoo Boy at $50 if I didn’t already own a bundle I’d bought at $100? Is Hoo Boy an investment I’d choose today on its merits alone?” If the answer is no, don’t throw any new money into the soured venture.
You might determine, of course, that the answer is yes. As the Tenth Axiom says, it is often profitable to bet against a majority. Perhaps your independent calculations will convince you that Hoo Boy’s troubles won’t last as long as most people expect, and that the $50 price level, therefore, is a genuine bargain-basement opportunity. It can happen.
But be very sure this isn’t just wishful thinking. If you are hunting bargains, the stock market and all other speculative worlds are always full of them. Before you throw that $5,000 into your second round lot of Hoo Boy, ask yourself: “Why into this particualr investment? Of all the potential bargains around, does this one really look the most promising to me? Or am I just trying to make myself feel better by averaging down costs?”
Like perseverance in general, of which it is a special type, cost-averaging clouds one’s judgment. Determined to pull your Hoo Boy investment out of the soup, you concentrate on Hoo Boy to the exclusion of other speculations that might be far better.
You’ve lost money on Hoo Boy and want to gain it back. But as we asked before in connection with Sears, why does the gain have to come from Hoo Boy? It’ll be the same good, spendable cash no matter where it comes form. Rid yourself of the Hoo Boy obsession and you vastly widen your field of choices and improve the chances of getting the gain you seek.
Another problem with this down-averaging dance is that it encourages you to disregard the important Third Axiom, on hope: when the ship starts to sink, don’t pray. Jump.
As we noted in our studies of that Axiom, the decision to take a small loss and take it fast is never easy and can sometimes be acutely painful. One looks for excuses not to do it, and one dandy excuse is the thought that one is going to make everything turn out right by averaging down. “Oh, I don’t have to sell out of this speculation now. I don’t have to do anything now. If it sags a whole lot farther, I’ll just buy a bunch more and average down…..”
So you sit there on the deck of the sinking ship, bravely refusing to move as the waters rise around your. Does it make sense? No, but you wanted an excuse for inaction, and that is what you’ve got. At a fear-filled time like this, it isn’t to be expected hat you will examine your excuse to see if it is logical.
Frank Henry knew a man who actually managed to talk himself into being happy when his speculations slumped. If he bought something and the price fell, he would buy more and average down his cost. The lower the price went, the more he would buy and the lower his average cost would fall and the happier he would become. This was one fancy psychological trick, but it kept him content.
It didn’t make him rich, however. He got stuck in some bad investments for years, continually averaging down and genuinely believing he was being smart.
Speculative Strategy
Now a quick review of the Eleventh Axiom. What does it counsel you to do with your money?
It says that perseverance is a good idea for spiders and Kings but not always for speculators. Certainly you can persevere in your general effort to learn, improve, and grow rich. But don’t fall into the trap of persevering in an attempt to squeeze a gain out of any single speculative entity.
Don’t chase an investment in a spirit of stubbornness. Reject any thought that a given investment ‘owes’ you something. And don’t buy the alluring but fallacious idea that you can improve a bad situation by averaging down.
Value the freedom to choose investments on their merits alone. Don’t give that freedom away by getting obsessed with one soured venture.