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Averaging Down vs Stop Loss?

Which is better in the long run?



In today’s video we discuss one of the most debated aspects of trading - Averaging Down, when it makes sense and when it doesn’t.

Broadly speaking, averaging down means buying more of the same stock or index as it goes down in price. Now, this might make sense for long-term investors who have studied individual stocks in depth and plan to wait it out. However, using the same principle in trading can be devastating.

let’s first discuss the psychology behind averaging down..

Most market participants start with a belief that markets always go up in the long run, which is often true if you know how to take that long-term approach. When you are trading however, the long-term outlook of individual stocks doesn’t matter as much because we are in with a shorter-term outlook.

The thinking gets tilted towards averaging down when the stock falls after initiating a long position. Rather than being disciplined in taking a loss, new traders become compulsive investors and that’s when the averaging down philosophy sets in. Some traders average down only with an aim of exiting at breakeven, without considering the growing loss should the stock continue its journey downwards. Many traders stuck in this situation take an eventual large loss and sometimes leave trading for good.

Even if the stock rebounds and continues its journey upwards, many traders, traumatized by their recent loss in value, end up exiting the position early, not realizing the full potential of the trade. Additionally, applying this approach on a regular basis can result in a poor risk to reward ratio. As traders we should desire small risk for large reward, whereas recovering from a recent price drop and climbing back to break even, often results in high risk, low reward, a recipe for disaster over the long term.

There are plenty of examples of how averaging down in individual stocks would have resulted in devastating outcomes.

But, let’s first understand where averaging down could actually make sense. In passive and systematic investing, averaging down can be a great tool to lower your cost base. It makes even more sense in index investing, because indices are diversified and have an inbuilt mechanism of shedding the losers and doubling down on winners - a strategy that works very well in the long run.

You can see a previous video of mine relating to my longer-term approach. In summary I invest in indexes after a significant drawdown, lowering my cost base and optimizing the use of capital.

Indices, especially the market cap-weighted indices, give the most weight to companies that have large-sized market valuations, and less weight to the lesser valued companies. The headline indices like the NASDAQ 100 and S&P 500 also have a limited number of stocks they consider to be included in the index. So for example, the NASDAQ 100 will only have the top 100 companies arranged by their market capitalization.

In their periodic rebalances, the lower-weight companies are excluded from the index to make space for new companies that have gained market capitalization since the last rebalance. This way emerging companies are included in the index and the laggards are dropped off. Some of these new inclusions continue to grow and their weight keeps on increasing in the index, pushing the index higher. The contribution from these growing companies makes up for the loss in laggards, resulting in a net positive outcome over long periods.

Because of this self-correcting phenomenon, the index always emerges from the down moves and trends higher over longer periods of time. Therefore, averaging down the index in bad times ends up delivering better than market returns.

Let’s look at an example using the NASDAQ 100’s chart over a 20-year period.

Despite several dips of varying degrees and lengths, the index always bounces back and continues its upward journey, led by contributions from growth companies including Apple, Google, Meta, Tesla, and NVIDIA. Whilst exiting laggards like America Airlines, Western Digital, and Fox Corp.

Because of the net positive impact of winners in the long run, the only thing you must get right is to choose the right index and the right time.

Let’s now see how this plays out in the case of individual stocks.

In the long run, Individual stocks tend to outperform on strong fundamentals and underperform on poor fundamentals. There are only a few stocks that continue to perform fundamentally for long periods of time. Something in the business landscape changes and many businesses fall by the wayside.

Let’s relook at the NASDAQ100 index to understand this. Since the beginning of the index in 1985, only four companies, namely Apple, COSTCO, Intel, and PACCAR, have always been a part of the index. That’s a sustenance rate of 4% over a 38-year period. All the other 96 index components lost their glory or were overtaken by new entrants that were growing better. Some of these companies ceased to exist after the demise of their businesses and some of them filed for bankruptcy. In many of these cases, the stock prices went to zero and stocks were subsequently suspended for trading.

Now imagine if you went in with a “stocks only go up mentality” against the 96 underperforming stocks. You may have averaged the stock all the way down only to discover that all of those shares were worthless. This of course doesn’t happen with all companies but happens with many of them. Therefore, a fundamentally uninformed trader can be in for a rude shock if he follows the averaging down philosophy on individual stocks.

A great example of this is the Financial Education channel run by the self-proclaimed investor Jeremy Lefebvre. Boasting over 600,000 subscribers it pains me to think how many people would have lost fortunes following his averaging down approach.

A few of his examples include; Voyager Digital, Tattooed Chef, Honest, Planet 13 Holdings and many more. Averaging down into these companies would have lost you huge amounts of capital, and often just as important, time and opportunity cost.

Another factor that works against new traders is that most of the time they choose high-flying stocks of the time to play the averaging-down game. This is an even bigger sin because many times those stocks never return to their previous glory. They get so overextended and overvalued in the euphoria that it gets tough to regain the glory once the business and sentiments normalize.

Let’s look at some of the recent examples of how averaging down in individual star stocks wouldn’t have worked in real life.

Here is the chart of Zoom Inc. - a company that started its meteoric rise at the start of the pandemic, when everyone needed a seamless video conferencing platform. The stock went up 8x in a few months. Subsequently, it started its downfall, coming back to the pre-pandemic price as the business faced tough competition from various other players, failing to capitalize much from its leadership position.

Here is the chart of another pandemic star - DocuSign. This stock also met the same fate as ZOOM - going up 5 times in a short period before coming all the way back down.

Let’s look at another example of what strictly not to do in trading. Yes, I am talking about Cathie Woods’ ARKK Innovation Fund. The fund started off well, delivering a 7x return in 8 years to 2021. This was when everyone thought that Cathie could do no wrong. She kept accumulating shares in overhyped and overvalued companies with no regard for risk management. As the portfolio started crumbling when the rally ended, she made another mistake of doubling down or averaging those falling knives to the bottom.

In some cases, like NVIDIA, Cathie exited right at the bottom of its decline, quite embarrassing for a fund claiming to be equipped with the best analysts in the industry.

The same was the fate of investors who continued to average ARKK on its way down. Cathie lost her face in the meltdown, but worse over the investors in her fund lost their hard-earned money just because the fund manager disregarded risk management. A simple 20 week moving average would have kept you in the position for most of its gains, whilst getting you out of the position saving you from most of the losses.

Even today when the NASDAQ 100 has recovered almost all of its lost ground, ARKK has at best seen a dead cat bounce. This shows how the odds are stacked against the “averaging down” trader or investor when it comes to individual stocks.

The biggest point to take home here is, that when you are trading, you always need to enter with a stop loss or at least some predetermined rationale to exit a position. Once that stop loss or rationale is hit you exit with no reservations. If you become a compulsive investor seeing the loss, or worse, if you average down, it wouldn’t serve your long-term trading interest.

Another point to ponder over here is that you will unlikely be successful by blindly averaging down individual stocks even when you have a long-term horizon. Such investing requires an in-depth study of the stocks concerned and a significant amount of time and resource to do so, something that only a very few have.

If you found value and would like to explore a more efficient approach to trading the markets, why not join our group of likeminded individuals, you can also gain access to our bespoke software to filter companies based on their fundamental and technical components.

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For those interested, we have a highly engaged group that uses our bespoke breakout scanner to find some of the best trades, offering low-risk high reward potential. Feel free to use the links below, and as always thanks for watching.

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