As with my other lessons that I have shared, this one is based around my experience. Maybe you will have a similar lesson or maybe you won’t.
If you want another article on the topic, check out this one by Ian from MCC.
Mindlessly Averaging Down
Like almost everyone I started reading some Buffett and Graham books at the front end of my journey. As I continued I read Lynch and Fisher. One of the overly simplistic ideas I took was that if something is cheap when you buy it, if it goes down in price it’s cheaper and you should buy more. This of course is not true all the time.
Of course, due to the liquidity profile of the businesses I invest in, there are many times when shares are up or down 20-30% for no reason. These gyrations test your conviction and are not what I’m referring to in this post.
The Set-up
I would find a company I thought would be a good investment (mostly just copying what another “investor” on stockhouse message boards said was cheap). I would take a position and stare at the share price daily. The share price is supposed to go up within a week of my purchase right? I was in good company with anon posters on the message boards and the shorts where keeping the price down. Those darn shorts. If I could only find one in person.
As time passed, the share price would drift lower and lower. And without thinking I would add. Then add some more again. My confidence was high. I was equipped with reading a total of 4 or 5 investing books, I had read all the Buffet letters so we were basically besties, I had no finance or accounting education to “get in the way”, an at best an average IQ, and the positive affirmations of anon posters on public message boards; what could I be missing? If it was worth buying at $10, why wouldn’t I buy it at $9? or $8? or $4?
As more time marched on, the share price would go lower and lower. I would think to myself “Wow! What a gift!” and I would add some more. Yeah maybe the last quarter was a bit weaker than I was expecting, but in a few years I will look smart. My forward returns where just getting better and better. It’s not like the market was really efficient or something.
At some point way past reasonable I would eventually start to think that I may have missed something. It was a small initial position that I was now way overweight. It was a Herculean effort to check my ego and look for holes in my thesis. Given my initial fixation on quantitatively cheap companies, many of these ended up being below average businesses. I was not going to be bailed out by the long term business fundamentals.
Over the years I have owned many companies that have gone down in price, here are a few reasons:
Poor company performance relative to the market expectations.
Fund flows out of the sector (more sellers than buyers).
Being removed from an index and passive funds must sell.
Rising interest rates hurting the terminal value of the business.
Company that is exposed to a commodity that is dropping in price.
The overall market dropping and the share price is following the index lower.
Some insider is selling and the market perceives this as a negative.
The market is sniffing out a potential equity raise in the near term.
The market knows nothing and this is an opportunity.
The last point was (and usually still is) the least likely in my experience. Of course me being naive, I thought the last point was the most likely for far too long.
Sadly, if I look hard enough I will have multiple examples for each bullet point above. Though I am not a person gifted with naturally high flexibility and strength, the mental gymnastics I can accomplish are Olympic level.
Closing Thoughts
Averaging down can be a good thing. Averaging up can be a good thing. Not being pragmatic about share price movements is a bad thing. It took me way too long to learn that the market is pretty good at finding the appropriate value for businesses. Any meaningful share price movement (or lack of movement) may hint at something below the surface that is worthwhile. Is the company about to announce something material? Are they raising capital? Are they about to be delisted? And so forth.
In order to combat the mindless part of mindlessly averaging down, I have set up some friction to slow down my impulsivity. There is nothing special that I do, but forcing myself to wait a specific amount of time before buying, checking in with someone who knows the story better than me or listening to the bear thesis with an open mind are a few of my tools. I have many more, but it’s context dependent.
One of the traits that accompany investing in microcaps is the illiquidity. So if I end up way overweight something that isn’t performing, unwinding the trade can take as much mental energy as listening to a room full of politicians setting carbon neutral targets. Or listening to someone telling me why eating nothing but red meat is healthy.
Anyone else have this experience?
Thanks for reading.
Dean
I highly recommend this classic. http://brontecapital.blogspot.com/2017/01/when-do-you-average-down.html