One of the first things (beginning) investors often do when the stock price of their stocks drop is buy more shares to lower their average purchase price. In market terms, this is called averaging down.
Warren Buffett once said he welcomed falling stock prices: "Lower prices simply mean I can buy more of something good." But that’s exactly where the danger lies. If the price drops, how sure are you that it’s still something good?
When the entire market declines, that’s a different story. But what if only your stock is falling while the rest remain stable or even rise? Should you still buy more?
I used to ask myself this question often. Today, I always buy in two phases, and in very rare cases, a third. This way, I partially limit the risk of throwing good money after bad.
Where do you draw the line between adding to a solid investment and making a costly mistake? How certain can you be of your analysis? What might others know that you don’t?
In short, averaging down isn’t a strategy to follow blindly. You need a certain level of arrogance to trust your own analysis more than others'. At the same time, you must be willing to challenge your own reasoning and seek out counterarguments.
Especially now, I see many investors rushing to buy as stocks drop. But as I wrote earlier: this is not yet a market crash, so buying in with enthusiasm may be premature.
Of course, there are always bargains to be found—they exist in every market. But what I often see now are stocks promoted on social media as “cheap” simply because they’ve fallen sharply. In reality, these are often extremely expensive stocks that have merely dropped to a lower level but they’re still overpriced. They’re not bargains yet.
No matter how great a company is, if you overpay, you’re still throwing good money after bad.
A small consolation: even professionals fall into this trap all the time.
Articles and updates this week
Last week, we only got the earnings report from K+S, where we're still waiting for a rise in potash prices.
This feels like the calm before the storm because, starting today, a wave of companies will be publishing their results at the last minute. That's typical for us as investors in micro-, small-, and mid-cap stocks. So, in advance, my apologies for the many emails you'll be receiving this week.
On Tuesday, we released the second part of Lesson 6 in our Introduction to Value Investing series: The Language of Companies – The Ratios.
Noteworthy this week: Roularta (an other Belgian company) received a takeover bid to be delisted from the stock exchange. And it won’t be the last. The offer seems even stingier than the one for Smartphoto.