Updated: Nov 17, 2020
Doubling down on your investment position (also sometimes called averaging down) is likely one of the most controversial tactics in investment. Reading a lot of investment books and articles I saw a lot of opinions on this matter. Most investment books suggest that averaging down is likely the biggest investing sin you can commit. You will see phrases like 'throwing good money after the bad,' 'increasing risk', etc. which are quite scary and make you want to stay away from this tactic forever.
Let's discuss this a bit more. Is doubling down really a tactic you should never go near?
First, a quick explanation of what doubling down (averaging down) means. Double down trading is constructed around an existing losing position and it's built by doubling your position when the stock price falls. Basically, doubling down means that you're buying as the market goes against you in order to improve your average order entry price.
EXAMPLE: Let's say you bought 10 shares at $100 each. A couple of weeks later the stock price dropped to $90. So you are sitting on a 10% potential loss. If the stock price goes back to $100 you are even. However, you decide to 'double down' and buy 10 shares more, now at $90. This brings down the average price of the 20 shares you now own to $95. Thus, if the stock price goes back to $100 you make a $5 profit on each stock you own.
First, let's look at the reasons for not doubling down that this tactic of doubling down that opponents frequently voice:
You are increasing your position for this one position, which increases your portfolio risk. This is particularly important if your strategy has a maximum % that you allocate to every position. Let's say, you allow yourself to invest a maximum of 5% of your capital into a single stock. Doubling down would mean you are breaking your strategy rule and increasing this particular position to 10% of your portfolio.
It may take some time to chase a falling stock. What if you doubled-down at $90 but the stock continued to decline to $80, $70, $60? Do you double-down again?
It is a dangerous technic for people with no strategy rule for how they will be doubling down. It also creates extra attachment to this stock given you invested so much money into it. Having invested 10% and having a loss may put a psychological resistance to close this position. This may ultimately transform you into a bag-holder hoping the stock will sometimes return to your average price. At that moment you likely going to be so happy to sell at break-even to get out.
Lost opportunities to invest in other stocks. While you hold the losing stock your money is locked preventing you from investing in better opportunities that can bring profit.
It is good if you have a cash reserve to double-down. However, sometimes investors close another position that is in profit to double-down on the losing position. This is referred to as 'throwing good money after the bad.' Indeed, many investors think that a profiting position is many times better than a losing one. If the stock price is trending up it would be a miss to sell it.
Now, having discussed the cons of the doubling down technique let's discuss why many investors, including some acclaimed investors like Warren Buffett, engage in it.
If you examine Warren Buffett's investment activity as well as his teacher's book, Benjamin Graham's "The Intelligent Investor" it seems that their investment idea is "if you liked the stock at $10, you got to love it more at $8 or $6". Just to remind, both are using a value approach to investing. Warren Buffett evolved this approach in his later career to make it more of a value-growth combination investment. However, the premise remains the same: buying great companies for good value. And the idea here is that you first research the company, make sure it is a good one on many fronts: its book value, growth, products, management quality. At this moment I usually think to myself: if I was a billionaire and could own the whole company today, do I want it. If you like it you weight in its value. Only when you believe the value for the stock is good and the market is truly not seeing the full picture, you buy it.
And yes, sometimes 'Mr. Market' may send the price of your stock even lower as the company you invested in is not in favor today. However, if you are an investor and not a trader you should be prepared to invest in a good company for 2-3 years.
Doubling down works for investors, not traders.
The idea is: the market will realize that it has been neglecting the great company that you found and its price will move up. Yes, you do need patience in investing. Mr. Market often neglects whole industries because other industries are in favor, sexier today and everyone is chasing those industries stocks.
Find great companies at great value and be prepared to hold 2-3 years.
If you think in these terms, you do realize doubling down makes sense. You researched the company, you know it is good, it is just that the market is acting stupid at the moment. So you are buying more of the company you like at cheaper prices which will result in more profit later on. Generally, this approach will work when you have a great eye for picking companies that will appreciate in the future, meaning your win ratio has to be good.
Talking about increasing risk with an increasing position, again, Warren Buffett was never shy to put half of his money towards just one company when he felt he is buying a great company at a great price. Now, I don't recommend you do the same. You don't have the ability to just go to investors and friends and ask them for more money to invest (like Buffett did early in his career.) But, if you have a rule of investing a maximum of 5% of your money towards one stock, you might make an additional rule that you allow to double down if you feel the company is worth it. You do need a clear strategy around 3 points:
At what point to double down. I personally don't chase 10% drops in price as I don't think this is too much of gain.
Once you decide how much of a drop needs to happen you need to also decide how many times you allow yourself to double down. Let's say you double down for the first time after the stock drops 15%. But then the stock drops another 15%. How many times do you allow yourself to double down? I personally allow myself to double down 1.5 times. Let me explain. Let's say I own 100 shares of company X. The first time I want to double down, I buy 100 shares more. Now, I own 200 shares. When I want to double down again, technically speaking, I need to buy 200 more shares. Instead, I buy again 100 shares. This still brings my average price for the stocks I own down, but it is not 'doubling down.'
You need to decide where to take money to double down. Your portfolio works best when all capital is invested. Now, you have this opportunity to double down. Where do you get the money? Do you sell the stock that is currently the most profitable? Or do you sell the stock that has not been moving for the past few months? This is a hard question to answer. Both of the above might bring profit in the future. Personally, I sell the stock that is in profit but is getting into the oversold territory. I also try to have at least 10% of my portfolio in form of cash. This is a good idea in any case as even if you don't need to double down you might suddenly find another opportunity that you want to grab immediately.
Now, unfortunately, everybody makes mistakes and you may as well call it wrong. I do suggest to double-check your assumptions about the company, make sure to review quarterly earnings reports and investor presentations to see if the company is still as great as you think it is. Also, when evaluating a company do try to take a step back and evaluate the company from all angles. Could there be an angle you are not considering? For example, the company may have great products and great growth potential, but it has the worst management that keeps increasing their salaries and sells their shares anytime the stock price goes up. This may be something that turns institutional investors away from the company and they start selling as well.
The hardest thing about the doubling down tactic is staying sane and true to yourself when the stock price moves in the other direction. What helps me is going back to my assumptions, checking the latest financial reports to confirm that I am right (at least 70% of the time) and the market is wrong.