Why is it that traders/investors averaging down? Seriously, what is the main rationale for buying more when you are losing on your trade?
Here is a simple answer: Greed
Here is a long answer: our being uncomfortable with seeing loss and want to make it right by buying more so that we can be “right” again sooner when the price turns back our way.
“Holy mackerel! It is getting cheaper! I’m buying more here!”
“It is so cheap here that I’m going to increase my portfolio allocation to this stock to buy more…”
“No F**kng way! how can it be??? The fundamental is so strong! I’m buying more here…”
“Oh crap! Not again! I’m not going to take loss here ’cause it ALWAYS go back up after I do. I’m buying more here!”
Regardless of the “thought” behind buying more when you are losing in the position; you are actually increasing your risk by buying more. Simply put, by buying more when you are losing, you are “multiplying your loss” even more when prices continue to go against your position. Whereas before your averaging down, the rate of loss is steady and all of a sudden, your rate of loss is 2x or more than before (depending on the magnitude of your averaging down) on every tick that go against you.
Size cuts both way.
Sure, many were able to “get away” with averaging down ’cause the prices did come back in your direction even though some had to wait a long time for it. Unfortunately, this only encourages the bad habit of buying more when you are losing.
“It works! I’m back in the black sooner! Wow, I’m making even more money now!!!”
And thus, buying more when losing becomes a tactic to use the next time you face the same situation. Averaging down will always work as long as the direction of the trade you are taking is trending the same way. And so the habit of averaging down continues to strengthen while the ability to cut losses becomes even harder to do.
Lo and behold!
A correction against the trend you are trading is taking shape…
“Nah, we are in a bull market! This correction will be over soon, I’m buying more!”
But… price keeps going down.
“Wait a minute… this is not right. My loss is deeper now… I can’t take loss here, what if the price goes back up when I’m out. Let me buy some more here so I can make it right sooner when prices head back up.”
Yet, price keeps heading down… and the loss accelerated as a faster clip because of the multiple averaging down
“Holy Shit!” Now, fear becomes a dominant emotion. Paralysis begins to set in.
Price goes thru a dead cat bounce..
“Thanks goodness. Come on baby! Get back up!” Instead of finding a point to get out to reduce the loss from this “godsend” bounce; all the energy goes into “cheering” for the price to go back up to make you whole.
“I think I buy more here since it looks like a bottom”
Price continues the downtrend but with a bit more zest..
“F**k!!!” By now, the portfolio lost 1/3+ of the value.
Need me to go on?
Think about it, if you cut your loss on a planned 5% stop loss in your stock, you probably loss only a tiny fraction of your portfolio when price changed direction. And what more, you are now sitting in more cash when the market continues its correction phase which may or may not lead to a trend change.
The good thing about taking your 5% loss (or whatever % you feel comfortable with) is that you are now giving the opportunity to buy back the stock as a much cheaper price after witnessing the deflating of the price on the sideline.
And if you truly believe in the fundamental value of the stock and choose to hold on to your position WITHOUT averaging down, you are in a much better position to handle the drawdown against you. Instead of witnessing a quick dead to your portfolio, you are flowing with the tide of the market like most of the investors out there.
Next time when you are facing a losing position, instead of letting your need to be right “sooner” by buying more, ask yourself if you really want to “increase” the risk of destruction first.
Averaging down may not get you right away, but eventually it will destroy you when you least expect it. Simply because by the time we realized the market trend has changed, it is already too late to save your portfolio from your averaging down.
If you enjoy the content at iBankCoin, please follow us on Twitter