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Scaling versus Averaging

Posted By Barry Ritholtz On April 23, 2006 @ 10:57 am In Apprenticed Investor,Markets,Psychology,Technical Analysis,Trading | Comments Disabled

I make it a habit to read people who’s market styles and/or perspectives are different than my own. One of my favorites in this category is Rev Shark. He is more of an active short term trader than I, reactive versus anticipatory, almost purely technical. I use elements beyond technicals, can be anticipatory, and try to trade less frequently.

But I find his perspectives quite interesting, and while he is much more bullish than I, his writings always have a healthy dose of wisdom in them. In all honesty, I read them as much for the differing perspectives as I do for his trading smarts.   

A recent piece of his is a perfect example: Averaging In, Not Averaging Down [1]:

"Many market participants have difficulty understanding the difference between averaging down an existing losing position and averaging in to establish a new position. I seldom average down, and I almost always average in. It may seem to some to be a distinction without a real difference, but to me the difference is like night and day. Averaging down usually involves adding to a position that is already established because of weakness. The thinking is that the market is wrong, and therefore I can get a bargain by buying as the stock downtrends.

Averaging in usually involves using the stock’s normal volatility to establishing a new position over time. I mentioned that I started a position in Broadcom (BRCM) today. I bought a very small amount last night when it traded down initially on earnings, with the intent that I would build a position. I had no set plans to make subsequent buys higher or lower. I simply wanted to start an initial position by making a few small buys. If the stock falls out of what I consider to be its current trading range, I’m not going to buy more. In fact, I’ll probably sell what I do have.

The primary difference between averaging down and averaging in is one of intent. When you average down, you generally do so because you believe the market action is wrong. When you average in, you are simply taking advantage of volatility and not making any judgments about how smart the market may be."

That’s a good explanation of the difference.

I would take it even one step further than Shark. When someone averages down — sometimes known as doubling down, because the stock has been cut in half — they are making a specific statement. By averaging down, they are reasserting that their initial purchase decision was the correct one.

In the very first Apprenticed Investor column, Expect to Be Wrong [2], I detailed the importance of an exit strategy. If you approach investing with a realization that the future is unknown and that you will frequently make  decisions that turn out to be incorrect, it becomes that much easier to preserve your capital.

And that’s the problem with averaging down: It is the refusal to admit an error.

I also take it as proof of the lack of an exit strategy. Just because you like a stock at $60 doesn’t automatically mean that you really like it at $50, adore it at $40 and are madly in love with it at $30. What it actually means is that 1) Your original analysis or your timing (or both) was off when you made that $60 purchase; 2) You lacked an original "error identificantion & correction" routine.

Get over it, cut your loss at an acceptable percentage, and move on.

If you are so enamored of the company, put a trailing buy stop on the stock so you end up owning it if it ever reverses its down trend. Just because you sold a stock doesn’t mean you cannot get back into it a different price level. Look at stocks like Apple or Google — you could have sold them on the trend break, and then restablished positions once they stabilized or reasserted their trends.

The bottom line is that averaging down is a suckers bet, an egotistical refusal  to acknowledge reality. Investing is a game of percentages — and the percentages state you will frequently make bad calls. Don’t wallow in misery, but anticpate them, and prepared to respond when they inevitiably occur. 


Averaging In, Not Averaging Down [1]
James Rev Shark De Porre
Real Money, 04/21/2006 11:10 AM

Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2006/04/scaling-versus-averaging/

URLs in this post:

[1] Averaging In, Not Averaging Down: http://revshark.rmblogs.thestreet.com/entry.aspx?q=e09c7812-6c9a-4feb-98e1-97aa00a7ccc2

[2] Expect to Be Wrong: http://www.thestreet.com/comment/barryritholtz/10215965.html

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