I NEVER Average Down. Maybe You Shouldn’t Either.

The typical thinking of investors, when confronted with an equity that has fallen in price, is to deem that company to be an even greater bargain than when it was initially acquired.

“If a company X has declined price by 20%, and I liked it before, then it must be true that the shares are a 20% better bargain than my time of acquisition. Why not double up on my purchase, so now I am only down 10%? When it rises, and it inevitably will, then I am going to make out like a bandit!”

The logic gap that flows from such thinking is that by employing the policy of “averaging down” investors destroy what Albert Einstein referred to as the “eighth wonder of the world“; the compounding of interest/return.

When you own an investment in price decline, any compounding effect is interrupted.

Adding more capital to that already reduced sum does not, in of itself, produce ANY compounding. More capital has been deployed, yet the actual dollar loss remains the same. Mathematically, there is no sum of money that one can throw at an established equity position that turns a loss to a break even, and a break even is still not a profit. Without profit, there can be no compounding of capital.

More importantly, as one has not factored in the time value of money, opportunity cost and potentially a “sunk cost fallacy”, impulses to dollar cost average are based almost entirely upon an anchoring belief; that you are a brilliant stock picker, this decline is irrational and therefore represents a buying opportunity only you can see, markets forces that drove down the shares are all wrong and you are right.

Dollar cost averaging down, via the very action of purchase, represents nothing more than a form of “ANTI-COMPOUNDING“.

Declaring it to be the throwing of good money after bad seems an extreme statement, but in reality, money IS being directed towards an equity that has, at least temporarily, produced a less than optimal return for an account as a whole.

Step back from impulsive thinking, for a time, and consider alternatives, including: “what if there IS a rational reason that the share price of company X has declined”, “what if the earnings potential of company X has been impaired or is due to be impaired and I have missed something in my thesis?“. Time away from any investment and spent on sober second thought might soften that urge to “average down” and evolve towards thinking along the lines of; “is THIS investment, at this price, the most PRODUCTIVE USE of new monies“.

I never average down on any equity. With an understanding that there are those in the markets with far more information at their disposal than I; when an equity falls in price, I search out new information that needs to be incorporated into the investment model. There is ALWAYS a reason for a share price decline; not finding it means nothing more than you didn’t search deeply enough, or that you found a reason/s and determined it/them to be unimportant. Should the latter prove to be the case, that a dismissal of details in a fact-finding expedition was premature, then get back to work and model accordingly.

My policy of not averaging down goes well beyond allocating new capital for investment; it also encompasses dividend reinvestment.

While investors readily reinvest automatically without forethought, due to the relatively small ongoing sums involved, adding more money to an investment that is either inert or in decline further defeats the power of compounding. Anti-compounding applies to each and every dollar, which includes dividends.

So, be it quarterly, semi-annually or irregularly, any dividend reinvestment undertaken for the portfolio is ALWAYS based upon the trailing price. If the share price is lower in any quarter than the prior quarter, that dividend is held aside to seek out the most productive potential use for those funds. Small sums add up and those small sums might provide the start up capital for an important secular trend investment not presently held in the account. Over a couple of years time, money held back from anti-compounding actions tends to permit a starting position in an equity that I deem to be highly desirable.

If nothing else, training yourself to resist the impulse to “buy more while down” represents an opportunity for sober second thought. Every investment decision, no matter the amount, should be a thoughtful one.

For the Gnostic Portfolio, there is no averaging down, only AVERAGING UP.

Averaging up is not a decision based upon pride, nor it is some anchoring belief of the possession of personal acumen over the street. Rather, it represents an acknowledgement of corporate success at the specific equity level; the markets have decided, collectively, an investment presently owned is still worth acquiring, even at a higher price than initially purchased. Furthermore, new institutional investors now feel the outlook is sufficiently attractive that they choose to invest in said equity above other alternatives. The act of averaging up affirms any prior purchase decision to be sound, with compounding taking place as a result.

There are relatively few articles on the subject of averaging up; fewer still published from the professional institutional perspective.

Compliance departments at many investment houses have written policies restricting credit to those who engage in the practice. They deride averaging up by nicknaming it “pyramiding“, or apply dismissive terms such as “hot hand fallacy” so as to make the practice appear unseemly. Yet, over 25 years, AVERAGING UP on existing positions of winning equities, such as Apple, Microsoft, Google, Mastercard etc was, financially, absolutely, the right thing to do.

Nvdia? Averaging up was about the only thing to do, because there were almost no occasions over the past decade when an opportunity to average down was even presented. But rather than further compound capital, investors were preoccupied with taking money off the table, reducing the compounding effect.

Whoever came up with the notion of “averaging down” as an investment policy must surely hate retail investors, or at the minimum, believe them to be incredibly gullible. Which implies that those who do the exact opposite of averaging down may be onto something. And, the investment industry hates talking on the subject of averaging up. It is their little secret.

I just bring it to your attention in passing. Don’t tell anyone.