Paul Tudor Jones, profiled in Jack Schwager's Market Wizards, one of the most successful fund managers of the 20th-21st centuries.

“Of all speculative blunders there are few greater than trying to average a losing game.”

–Jesse Livermore

Average down.  Of the many age-old trading maxims this was one of the first that made me pause and wonder.

For a number of years I’d simply assumed this to be one of the popular falsehoods foisted on the unsuspecting public.  Imagine my surprise when I heard it regularly parroted among seasoned pros on the trading floor.

“But it seems to always work great”

Averaging down takes place after you’ve put on a trade and prices go down instead of up.  According to average down enthusiasts,  although prices have dropped below the level of your first purchase, if you go ahead and buy more the net effect will be an average entry price lower–thus even more favorable–than your original purchase price.

Should prices continue to drop, they say, buy even more to make your average entry price  even more favorable.  When prices eventually swing upwards you’ll be in an even better position as a result of averaging down than you would’ve been with your original purchase alone.

.

The Underlying Assumption:  Prices Always Recover

If you’ve tried this before–it often works great.  However, if you apply critical thought to the process, you’ll quickly see the whole idea of averaging down is based on one big assumption–prices will come back up  (i.e., before your peace of mind/account/investment fund/ risk model implodes).

Death by way of Black Swans, Outliers, and “Exogenous Price Shocks”

I classify averaging down as a “negatively skewed” trading strategy.  In simple English, this refers to a strategy that works favorably–even wonderfully–the majority of the time.  BUT–the one time it doesn’t work, for instance when prices drop more severely than you’ve ever experienced, you may be looking at risk of ruin.

Take a look at the following:  Imagine you bought at the first “buy” point, but then prices prices drop.  Bummer–but not to worry.  It’s averaging down to the rescue.

Averaging Down to an Untimely Death

You make your next purchase at the 2nd “buy” but much to your chagrin prices creep lower.  Undaunted, you make your third “buy” only to see prices go into a heart stopping free fall.  Trying to recover your senses, you try convince yourself about the very low average entry price you’re getting, despite your hemorrhaging account equity.  You buy again with teeth clenched.  But prices continue their relentless southward march.

You remember hearing in a Fibonacci workshop retracements rarely go below 61.8%  When your first purchase is down 70% you start hiding your account statements fearful your wife is going to kill.   You can no longer think straight, so…your next buy is on a wing and a prayer.  Finally, when prices dive another 5%, you capitulate–at the worst possible moment.

This is just an example.  You’d be surprised how many investors’ accounts–individual and professional–died an untimely death in a way very similar to this by attempting to average down into a market which simply never came back up.  At least, not before the psychological trauma became so great they either threw in the towel or the fund’s investors stampeded for the exits.

This is hardly a new teaching, by the way.  Consider this excerpt from from a popular trading manual written in 1878:

It is better to “average up” than to “average down.” This opinion is contrary to the one commonly held and acted upon; it being the practice to buy, and on a decline to buy more. This reduces the average. Probably four times out of five this method will result in striking a reaction in the market that will prevent loss, but the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss – a loss so great as to bring complete demoralization, often ruin.

–Speculation as a Fine Art, Dickson Watts

Never mind what you hear from other investors, learned in a seminar, or read in a book.  When it comes to averaging down, let’s humbly remember Paul Tudor Jones’s personal advice:  LOSERS AVERAGE LOSERS.

.

E. M. M.

For more strong medicine see

Be Careful Who You Listen To

“What’s the Hot Stock?” And Other Indications of Probable Ruin

“Your Average Broker Couldn’t Be a Trader In a Million Years

E. M. Murray. Managed Equities. Fixed Downside Risk.