## Friday, 21 October 2016

### The Math of Averaging Down

What's the difference between a -80% loss and a -90% loss?

50%.

In years gone by, you probably would have made good profits by spotting arbitrage opportunities!

But now, its a lot harder with high frequency trading and all...

Show me, show me!

For the rest of us mortals, let me illustrate:

1.  You bought a stock at \$1.00

2.  At -80% loss, the market price is \$0.20

3.  At -90% loss, the market price is \$0.10

Still want to average down when price is at \$0.20?

Price so low oredi, surely it can't go any lower?

Well, a "small" additional decline of \$0.10 is now a 50% loss for your 2nd entry!!!

Now you know why people capitulate (sell) at crazy super low prices.

Especially to the "iron teeth" (stubborn) ones  who will continue to average down a third time at \$0.10 price.

See what happens when price drop further to \$0.05 cents?

Don't try this at home

Of course you were banking the reverse would happen when you averaged down.

a.  You invested \$10,000 into stock XYZ at \$1.00

b.  At market price of \$0.10, you average down another \$10,000

c.  When price "recovers" to \$0.20, you sell both tranches with a big sigh of relief...

First tranche:                Entry at \$1.00; exit at \$0.20 = -\$8,000 loss

Second tranche:           Entry at \$0.10; exit at \$0.20 = \$10,000 profit

Hey! All in all, you've made a \$2,000 profit!!!

Really? Risking all these money just to "break-even"?

Tip: Don't play Poker or Mahjong with real money - you lousy with risk/reward odds.

What?

You still got the cheek to "advise" people not to gamble...

Be honest now

Which is the likelier scenario to play out?

How good is your entry skill?

You did buy at \$1.00, remember?

What makes your such an expert market timer now so super sure \$0.10 will be the turning point?

And more importantly, you did let a \$1.00 position slide all the way to \$0.10 - that's not saying much about your exit skill, does it?

Do you honestly believe you will exit everything when the price hits \$0.20?

Or maybe you are the white-haired demon girl (白发魔女); you changed completely in one night.

If you can do so, I clap my palms before you. And bow.

Namaste (I salute the holiness in you)

1. Hi SMOL

Nowadays, it doesnt take a share price to drop to \$0.01 before it gets suspended. \$0.01 consolidate back to \$1 and then drops to \$0.01 and then consolidate again. Wah, 1 cent so cheap cheers!!!

1. B,

Ah!

The reverse stock split ;)

Don't know whether to cry or laugh when you can't even breakeven with a 10 bagger!?

Letting go is something we have to learn and master...

Children all grown up with their own families? Letting go...

My job has been taken over by a machine? Letting go...

Love of my life marrying someone else? Letting go...

Stock turned salty fish? Letting go...

Losing my hair at the top? Letting go...

LOL!

2. Don't average down. Then how? Many are thinking like that!

1. CW,

I never say don't average down ;)

Don't try this at home means unless you are a pro and know what you are doing, don't monkey see monkey do.

If you have trained and prepared for it, at age 80 also can run a marathon!

But if you have not trained for it, even at the peak of our health at age 18, we'll likely hurt ourselves...

The irony is that some of those who think like that are the same ones who - with good intentions - like to "wah kali kong" and preach to others not to use leverage/margin for investing and gambling is bad for you.

If they only knew the risks they are taking on by averaging down just to break-even...

3. SMOL

Letting go is difficult.

If we take out the emotion for every decision we make, wouldn't it make us a lifeless person.

If that's the case, what is the point of living?

1. Blursotong King,

Emotionless is not the same as not letting emotions get the better of us ;)

Extreme frugalness is similar. What's the point of living in such an austere manner?

So is the greed and never ending accumulation of money in the name of "financial freedom".

Hence we walk the middle path.

Similarly, wisdom is needed to avoid the extremes of being emotionless and emotion overflow ;)

Letting go is non-attachment.

I better stop as that's a whole different realm of philosophy altogether!

2. SMOL

Care to share more about the philosophy part? I am interested to learn

3. Blursotong King,

I'm not qualified. It's a big subject and if not careful, can lead you astray...

Just suffice to give you some hints that non-attachment is not detachment.

Neither is it lack of love or compassion ;)

If you interested in Non-Attachment, just google "non-attachment" and have fun getting "lost" for a feel of things.

Once you have a better sense of it, you can start to explore Buddhist books in the library.

If still interested to practice it, private message me and I can direct you to some of the courses out there run by reputable Buddhist organisations.

When I first came back 5 years ago, with time on my hands, I attended the Christian Alpha course and finished 1.5 years of a 3 year Buddhism course before I dropped out - it got boring...

Quite interesting counter-balance:

Spiritual freedom vs financial freedom ;)

4. There is a saying, "Not until you can control your emotions, can you control your money."
i completely agree.
If we can do things without any emotions, what have we become?
Robot, zombie, .......
The best we can do is put our emotions under lease.

1. Should be, "Not until you can control your emotions, can you manage your money".

2. temperament,

One of the disciplines I've gotten better in recent years is the awareness of my emotions.

I'll stay on the sidelines, reduce my position size, or take a break from trading whenever I caught myself having too much emotions vested in my positons.

As a man of leisure, I must maintain my air of debonair ;)

3. For awhile, I read Dragonair Pokemon. :-)

4. CW,

I've not played Pokémon; but I've flown Dragonair a few times during my time in Shekou (Shenzhen) ;)

Power name - Dragon Airlines!

5. Hi SMOL,

It's true. Don't anyhow average down unless you want to flip until you go longkang. I've done it in the past and lost terribly. Now I follow bro8888 and average in. Doesn't matter whether I'm buying higher or buying lower. I'm entering the same counter but with a new thesis behind the new purchase haha

Best to treat each purchase, even if it's the same counter, as if they are separate and independent purchases!

1. LP,

In trading's parlance, we call it:

Scale in; scale out.

We all have to learn it the hard way (including me).

Can be quite hard for newbies to differentiate - when the pros do it, they appear to be doing the "same" when it comes to execution...

But there's a REAL difference.

Only those who survived from their averaging down "temporary insanity" episodes will understand ;)

Experiential bloggers like us share our "war time" stories and reflections.

We have battle scars to back-up our reminisces ;)

6. Hi Smol,

I just written a post after reflecting on what you said. It got so much clearer after writing (as usual)

As u said, average down by itself is a ok strategy, if we are sure what we are doing. After my reflection, the irony is my winning positions, only 1-2 counters have the "opportunities" to average down.

But a few counters did break even after averaging down.

The real slap is averaging down then sleep on it. Once we average down, the managitudue of fall is "doubled" and we should cut.

Connecting the dots now, until the next big bear refresh and reset my journey

1. Sillyinvestor,

I understand what you meant.

Again, I never said averaging down is an OK strategy.

Notice why I persist in correcting you and CW when it comes to "precision" in language?

Words by themselves are not important; but we should always be mindful on the power and influence of words have on our psychology ;)

My post is merely a carrot and stick coaching technique to encourage the reader to reflect and seek the answers themselves.

Whether averaging down is a good, bad, or useful in specific situation is entirely up to EACH and everyone to decide for themselves.

As you have discovered, sometimes it works; sometime it doesn't.

2009 to 2016 is a bull cycle. Averaging down in a bull cycle - that's your reflection.

For another reader who has gone through the bear cycle of 2000-2003, his reflection of averaging down will be totally different!

In the next bear cycle, your reflections will get "refreshed and updated" as you go through a multi-year bear cycle yourself ;)

Just remember 2 things:

1) We don't invest to break-even.

2) Stay alive!

No chips; no play :(

7. Can we use size positioning instead of averaging down?
Are they the same?

From so many financial books I have read, almost no author recommends averaging down.
But some have recommended averaging up.
I mean 1 lot, 2 lots......assuming everything is being equal.

1. temperament,

Position sizing and averaging down are not the same.

Let's say you limit a stock to not more than 5% of a portfolio. That means even if the stock goes to zero, the max loss is only 5% at portfolio level.

5% of a \$100,000 portfolio is "only" \$5,000.

5% of a \$10 million portfolio is \$500,000! Some how I don't think you would shrug it off so lightly ;)

1 or 2 lots no feeling. Hundred thousands of lots then we are talking!

As for 1,2,3,4,5 or 5,4,3,2,1?

No need to guess. Just experiment on your own and let your own experience and track record tell you which is better ;)

Don't let anyone tell you what shoes you should wear! Unless you don't trust your own feet ;)

My own experience is there is be a BIG difference in psychology when I average down versus average up.

One path is going against the wind; the other is moving ahead with the wind behind my sails ;)

2. 5% of \$ 100000 and 5% of \$ 10,000000 in absolute value is not the same is true.
But size positioning is the same.
Therefore risk management is the same for both persons.
So the \$10,000000 person may indeed shrug it off if that's how invested.
And perhaps it's the \$10,000 person that may not shrug it off.
i know, I have been the \$10,000 person too often.

3. temperament,

In percentages, its the same. In dollar amount, no way!

Sometime back, a fee-based financial adviser was poking a client for being too "kan cheong" with a small 1.5% loss on his portfolio.

Hello! the client's portfolio is \$100 million, and 1.5% is \$1.5 million! Enough for a condo!

That's why I don't like to think in percentages. I prefer to use dollar amounts.

I only doubled my trading's position size even though my trading account is now a 10 bagger.

This is the optimum position size where I can cut-loss in dollar terms without hesitation nor blinking an eye ;)

4. i concede in theory there is no difference between thoery and practice but in actual there is.
So size positioning and hence risk management in theory is the same for all of us.
In practice is it really the same?

5. temperament,

Your mileage and my mileage may differ ;)

This is the fun part of blogging I enjoyed very much!

To banter with people who are smarter and more experienced than me ;)

6. Oh no!
Experienced may be for i live at least a decade more than you.
i really don't worry who is smarter or not.
i only worry my decision is not mine even after considering all others ideas.

How about you start a business i will join you as a junior or sleeping partner?

7. temperament,

I'm too lazy and irresponsible to run a business.

I did seriously thought about it before I came back. To buy a franchise like 7-elevan or Subway.

But the moment I realise I have to spend most of my time on recruiting manpower and dealing with work permits; and "working for" the landlords in reality, I gave it all up.

Trading from home and treating it as part of a nano hedge fund business has worked out much better than I've imagined.

I quite like my Ronin status today ;)

8. Ha! Ha!
Exactly why i am in the stock market and not in any business.
We are really have something in common here.

8. Hi SMOL,
Yah ! This is my problem as well ,, average down on Sembcorp Ind ,,,jatuh lonkang,,, average down on M1 also masuk lonkang ,,, : (
Think temperament have a good question to ponder,, whether we should use sizing up or sizing down strategy ,,,, my interpretation will be sizing up if we still have war chests,, sizing down when we are running out of bullet.... :). Just kidding
Cheers !! :)

1. STE,

I would like to hazard a guess you now know WHY Sembcorp Ind and M1 have gone down ;)

That's the price to pay for "certainty" in knowing the fundamental reasons.

Some would prefer to sell first and ask questions later. These are those who focus on market psychology - also known as technical analysis ;)

And when the dust has settled, they can decide with a clear and calm mind whether to re-enter into the SAME stock they have exited earlier - now at a much BETTER entry price, if its still a high conviction buy.

Note this is not averaging down since no NEW capital is injected. It's still the same old capital - albeit "recycled" with a "hair-cut".

This is still aligned with position sizing, you are sill using the same 5% max allocation limit for this stock.

Many retail bei kambings started out with max 5% limit, then they average down in anger/frustration to get even...

Before they know it, this lemon of a stock is now 20% of their portfolio???

Talk about letting a small paper cut turn gangrenous...

What happened to discipline and sticking with their investment plans and their goal setting for the year?

No one ever set investment goals to breakeven...

Its best to listen and trust our own track record. If averaging down works for you, do it!

Why change a winning strategy?

LOL!

9. Why change indeed?
If sailing upstream against the Current you succeeded, how much more you will achieve if you sail downstream?
I think at which point of the river you started and ended your sailing journey is the most important consideration.

10. Hi SMOL & temperament,
Yah. .is very true. .I like the comment on " which point of the river you start. ..." is very much depend on which part of the biz or economy cycle we are in ...that will determine our wining ...not only hindsight of any strategy or stock picking. . I guess. .:)
Cheers.👍

1. STE and temperament,

Yup.

If we are always averaging down, I guess its a great tell tale sign we are not buying at the bottom end of the business cycle ;)

And definitely not practicing: