from Daily Reckoning
— this post authored by Greg Guenthner
Want to learn how to avoid losing your shirt in the market?
Then pay attention because brokers and financial advisor have been giving you one of the most god-awful pieces of advice. Most folks believe it – and unfortunately, investors like you have lost millions of dollars because of it…
So today you’re going to learn how to avoid that hideous mistake. I’ll also show you a simple trick that’ll limit your losses and let you make more money on your profitable trades. Maybe a lot more.
The Wall Street lie I’m referring to is commonly called averaging down. It means buying additional shares of a stock when the price drops. The idea is that the investor is lowering the average price he pays for shares. Because if you liked a stock at $50, you’ll love it at $35, right?
Wrong.
See, in most cases, averaging down really means spiraling down…
Let’s say you buy 1,000 shares of a $10 stock. It’s a company that owns a small fast-food chain. Your research shows the company’s planning to double its number of restaurants from 50 to 100 over the next three years. So you put $10,000 on the line, expecting shares to rise as the company expands.
Unfortunately, the expansion doesn’t exactly go as planned. The economy softens. Sales weaken at existing stores. The company’s margins are pinched as consumers crack down on spending and demand larger discounts. Finally, an earnings miss sends shares plummeting double-digits in one day.
It’s been one year since you first purchased your 1,000 shares. Now your $10 stock is trading at $5 and your $10,000 initial investment is now only worth $5,000. But you still like the stock. You believe the company will right the ship when economic conditions improve. So does your broker.
So you buy another 1,000 shares, paying just $5 per share this time. On the surface you can easily justify it. By purchasing another 1,000 at a discount, you’ve effectively lowered your average entry price to $7.50 per share.
You’re doing what every financial advisor tells you to do here. Sit on your hands and stick to your belief that the stock will eventually go up…
But that ain’t how the market works, buddy. Averaging down is throwing good money after bad. It’s usually a sucker’s bet. Instead of improving your situation you’re tying up even more money on a losing investment. Using our example, your stock would still need to rise 50% to bring you back to breakeven. The starting line. And that’s after you’ve already doubled-down on your investment.
That’s money that could have been put to use buying another winning trade.
That’s precisely why you need to change your investing mindset. The lie of averaging down only causes pain and suffering. And I don’t want to hear about that rare occasion when it works. For every one of those you get ten when it flops.
So it’s time to break the cycle by going against what nearly every financial advisor has preached since the beginning of time.
And instead of buying more shares of a stock when the price drops, you should “average up.”
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That’s right – average up. Add to your winning positions. It’s not crazy. After all, why wouldn’t you want to buy a stock that’s going up?
Take a look…
I know this might sound strange. But it’s a strategy that many successful traders and investors have used for decades – even though it’s rarely mentioned.
If you have reason to believe a trend will continue, you can add to your winning position multiple times. Just be sure to limit your risk by moving up your stop loss each time. That way, you won’t lose money if the stock unexpectedly drops below your most recent purchase price.
Averaging up works for two key reasons. First, you’re actively building a position in a winning stock. Instead of idly watching your gains, you’re increasing your profits by moving additional money to your strongest positions. It compounds your gains.
You’re also making your money work for you on your own terms. When you buy into the lie of averaging down, you’re forced to expand your investing timeframe. One year becomes three years. Three years become five years. Before you know it you’re holding an investment for half a decade – and you’ve pulled out whatever’s left of your hair waiting for the damn thing to break even.
Averaging up breaks this cycle of disappointment. And it’s not rocket science. If you average up consistently you’ll be rewarded with larger, faster gains. And you’ll never throw good money after bad again.
So tell your broker to get bent next time he says to average down…
