Should you Average Down or not?

I first heard of the concept of "Averaging Down" over 3 decades ago.

It started off with positive intention from its cousin "DCA" or "Dollar Cost Averaging".  Instead of investing say RM120,000 at one go, you should consider buying RM10,000 per month over 12 months instead.  If market goes up and goes down and by the end of the 12 months ended up exactly the same price, you'll end up owning more shares, than if you had bought it all at one go at inception.

Dollar Cost Averaging (DCA)

Here's an illustration of DCA.  Imagine you have RM120,000 to invest when Price is RM1.  If you buy at one go, you'll have 120,000 shares.

Now, consider the alternative method - break the RM120,000 into 12 equal parts and invest each month.  Price goes up and down during the next 12 months and if price gets back to the same RM1, you'll end up owning more shares due to the price volatility.  In this illustration, when price went up, then, come down, and then recover back to RM1, you'll own more shares at 124,049 shares, instead of 120,000 shares.

So, why does DCA work in flat markets?   

Simply put, it forces you to buy more shares when price is low, and forces you to buy fewer shares when price are high.  

As a result, 12 months later, you own more shares with the same outlay.

So, summary pros and cons of DCA.

Pros - Works great in 2 kinds of markets:

1. Flat markets and
2. Markets that declines temporarily and 100% sure to recover back (nobody knows the future though).  

Cons - 3 important disadvantages:

1. Not so good in rising markets (you'll end up owning less shares in a rising market)
2. You'll lose much bigger in $ terms if it goes down and stays lower than your entry price forever
3. The worst of it is when it goes down to zero (then, you'll lose everything).

Averaging Down (AD)

So, what's the difference between "Averaging Down" and "DCA"?

The difference is when prices are higher - you don't buy.  You only buy when prices are lower.

So, this has pros and cons too.

Market Type 1 - Volatile flat market - a market that goes up/down and eventually comes back to original price. 

1. In this type of market, Averaging down has pros and cons relative to DCA. 
2. If you believe Position Size determines your final returns more than Entry Price, then, DCA  typically gets you to full Position Size than AD, because in DCA, after "n" month, you'll end up with full Position Size regardless of whether market goes up or goes down.  Whereas AD might only get you a tiny position if after the initial move down to give you 1/12th the position, price then went up higher than stayed higher.  
3. However, if you can get in full position with both methods, the difference is likely to small in the long run after 100 stocks.  In practice, you're unlikely to get a full position with Averaging Down in all 100 stocks.

Market Type 2 - Rising market - the market price keeps rising to be higher than original entry price

1. In this type of market, DCA is superior to AD because it keeps adding more shares on the way up to full position size, to give you a bigger $ win, whereas under AD, you only have 1/12th at entry and then, that's all you have.
2. In a generally rising market (and if you have 100 of such markets), DCA is clearly superior than AD simply due to differences in position size.

Market Type 3 - Declining market - after entry, price keeps getting lower and lower

1. In this type of market, if the total outlay is the same, then, both are similar and the same.
2. Over 12 months, you keep buying more at lower prices and eventually, you'll own a full position.
3. If price goes to zero, in both cases, you lose everything whether DCA or AD!

In conclusion, which is better?  DCA or AD?

According to Buffet teachings on stock selection, neither is better.

What is more important is it's future price action.

If the stock's business economics is of superior quality (e.g. it is in a superior type of business, a monopoly, have an economic moat, etc.), is run by able, honest and trustworthy management, and is available at an attractive price (where future price will be higher), then, it's future price action is likely to be rising.   Then, your risk here is not getting a full position.  You don't want to be owning only 1/12th of a full position - here, DCA is superior than AD, but an immediate buy at full position is superior than DCA, if you have picked the correct stock at the right price.   However, if you have 1-2 months to accumulate, then, odds are usually some form of averaging typically gets you a little bit more shares but in the long run, they don't make much difference, compared to finding that superior stock.

In short, future price action is key.   You want to find a rising market, where the price action is likely to be rising, where "a rising tide raises all boats".

And if its future price action is downtrending, and possibly heading down to zero, then, avoid at all cost.  

• Don't even bother to own a piece.  
• Ignore, disregard and move on to other markets.   
• There are thousands of stock with markets to trade.  Get in them.  
• Don't be stubborn.  Let go of your losses and move on to find new markets where future price prospects are likely to be rising.   
• Invest there, so that your portfolio keeps making new all time highs!