Buying more dresses

Investors often tell me if one of their stocks drops by a significant amount, they might buy more to take advantage of being able to buy more shares and reduce their cost per share. They do this in an attempt to try and make even more money by having more shares, expecting an eventual rebound. This action of adding more shares to an existing position at a lower price is called "averaging down." Although the strategy sounds good and may actually work according to plan, the concept has its flaws and, in my opinion, is exactly opposite of what an investor should do. The strategy also defies common sense. An analogy which might have you better understand why averaging down might not be such a good idea is to think of a dress shop owner. Suppose a particular style of dresses the owner has in stock is not selling. After weeks of sitting on the shelf, the shop owner goes and buys more, trying to average down his cost per dress. Common sense would make you wonder why they would do that. After all, the dress is not selling, is obviously not in favor by the customers, and buying more of them will only make the problem worse. In an attempt to average down, the owner now has even more of a product that is not moving off the shelves. Doesn't make much sense, does it? The same might be true in the stock market. After all, buyers of stock fall along the same lines as buyers of anything else. When a stock is falling, it's also falling out of favor. Which is to say people are selling it because they don't want it. Much like the dresses sitting on the rack untouched by the customers, the shares of stock are also being ignored and even dumped (sold) by market participants. There are reasons why a stock goes down and there is no telling when the selling will stop. People might have a hunch why investors are dumping it, but no one really knows for sure when the stock will halt its descent and go back up. If the stock keeps dropping, some investors will even buy more of it in an attempt to average down again. On the flip side, imagine the shop has a dress that is flying off the shelf. Would a casual observer fault the owner for buying more of the popular and in-demand dress? Of course not. The same might hold true for stocks. If a stock is running, think of it as a dress that is flying off the shelves. Because it is in high demand, the shop owner might even have to pay more for the next shipment, as increased demand means higher prices and that price pull would often bleed over to the maker of the dress. In the world of stock, this means a higher stock. The strategy of buying more of something when it is rising in price is called "averaging up," and in my mind, averaging up makes a hell of a lot more sense than buying more of something that is not currently in demand. In the stock world, buying stocks that are rising is called "momentum trading," and a case can be made using that strategy of investing. When thinking back to the dress shop, it makes a heck of a lot of sense and the analogy seems to clarify why averaging down might be a losing proposition. Don't get me wrong. Sometimes, averaging down can turn even bigger profits. But it can also turn into larger losses. And there are caveats everywhere on trading on momentum. Another word for momentum trading might be construed as "chasing'' a stock, and that too can be hazardous to one's financial health. But more often than not, I hear about one investor or another buying more of a losing stock, and usually, it's the novice trader. Remember, in the world of the big-boy traders who often invest large sums of their own money, cutting losses is the norm, not adding to them. A case could be made for both averaging down and up, as well as dumping your losers altogether. But sometimes, trading doesn't have to be rocket science. It can be more like just using plain old common sense. This article expresses the opinion of Marc Cuniberti and is not meant as investment advice, or a recommendation to buy or sell any securities, nor represents the opinion of any bank, investment firm or RIA, nor this media outlet, its staff, members or underwriters. Mr. Cuniberti holds a BA in Economics with honors, 1979, and California Insurance License #0L34249 His insurance agency is BAP INC. insurance services. Email: news@moneymanagementradio.com