In a previous article, I introduced the concept of money management, or what is often referred to as capital preservation, by discussing Martingale and anti-Martingale betting strategies. Today, I want to explore a common pitfall among novice investors: the practice of averaging down.
What is Averaging Down?
Averaging down refers to buying more of a stock as its price falls, thereby reducing your average purchase price. It often goes like this:
You purchase a stock at 500p per share. The price subsequently drops to 250p per share, so you decide to buy more at this “better” price. This reduces your average purchase price to 375p per share. At first glance, this seems appealing because it implies that a smaller recovery in the stock’s price is needed for you to break even.
The Danger of Averaging Down
Now let’s consider the risk. Suppose you started with £20,000:
- You initially invested £10,000 at 500p per share.
- When the stock halved to 250p, you invested another £10,000.
If the stock recovers and skyrockets, you’re a hero. But what happens if the company collapses? You’ve lost everything. Game over.
If this scenario seems too extreme, let’s tone it down:
- You invest £1,000 at 500p per share.
- When the stock drops to 250p, you invest another £1,000.
- If the stock halves again, you invest another £1,000, and you continue this pattern all the way down to zero.
Now imagine doing this with stocks like Woolworths, Southern Cross Healthcare, or Connaught over the past few years. These companies went bankrupt, leaving many investors with nothing to show for their persistence.
Diversification Won’t Always Save You
In theory, diversification should protect you. If you’re invested across 20 different stocks, the failure of one or two shouldn’t ruin your portfolio. But if you’re using an averaging-down approach, those failing stocks can become magnets for your capital.
Why? As you sell profitable positions to fund additional purchases of losing stocks, your portfolio’s composition gradually shifts. Over time, it becomes dominated by those underperforming positions. What started as a diversified portfolio can quickly concentrate into a handful of “dog stocks.”
How Does This Apply to Spread Betting?
Now, for some good news: in the context of spread betting, the mechanics of averaging down are somewhat different.
When you average down using a fixed pounds-per-point basis, the additional risk you take on decreases with each subsequent trade. Here’s how:
- Betting £1 per point on a 100p stock risks £100 (assuming no stop-loss order).
- When the stock falls to 50p, betting £1 per point risks only £50 more.
- If the stock drops further to 25p, your additional risk is just £25.
Each time you average down, your exposure is reduced. From a money management perspective, this is closer to an anti-Martingale approach.
Important Caveats
While this strategy limits additional risk, it’s not without flaws:
- Total Loss Potential: If the stock ultimately goes to zero, you lose everything you staked. Averaging down doesn’t eliminate this possibility.
- Account Protection: Always ensure that your cumulative losses do not wipe out your entire account. Capital preservation should remain your top priority.
Final Thoughts
Averaging down can be tempting, especially when a stock seems undervalued or poised for recovery. However, it’s crucial to recognize the risks involved and avoid throwing good money after bad. Whether you’re managing a traditional investment portfolio or engaging in spread betting, proper risk management is key. Know your limits, diversify wisely, and resist the urge to chase losses.
