What should you do when a position you believe in moves against you 10% in a few days? This question is a simple one, yet it leads to drastic differences of opinion.
Certain investors believe that if you were willing to buy the stock at a higher level, why not buy more now. Others feel that all investments should be closed after an adverse move and that you should never add to a losing trade. Where do I fall in this argument? Somewhere in the middle.
If you believe in the quality and value of your research, averaging down into a losing trade makes perfect sense. However, the dangers are obvious. Some of the legendary investment failures - Long Term Capital, Nick Leeson – involved averaging down into losing trades. Closer to home, anyone who blindly averaged down into Fannie Mae, Lehman Brothers or AIG has seen bad trades turn worse. With such large risks in averaging down, how do we decide when to cut losses and when to push our luck?
When a position moves against you, ask yourself three questions to determine your next action:
- How much faith do I have in the initial analysis? If you believe the thesis is correct and the market has missed some key factors, stick with the trade.
- Am I being flexible enough? Even if you believe you are right, you must process all new data objectively. If you made a mistake in the initial assessment, it is time to move on.
- Can I live with a quantified downside? Average down into the trade only if you can survive a worst-case scenario.
An example of how I have implemented this process in my own investing is my purchase of the Ultrashort Lehman 20+ Treasury Proshares (TBT). As outlined in my weekly newsletter EPIC Insights, I believe the rush into Treasury bonds has created the next bubble that will burst. With that thesis in mind, I bought a position in TBT at $43.81. Two weeks later I had an unrealized loss of 18%, dollar cost averaged into the shares and lowered my cost basis to $40.19. With the shares trading at $42, I now have a 5% profit as opposed to a slight loss.
In order to justify the trade, I examined my initial thesis. I determined that I had honestly processed all relevant information and that may thesis was sound. A Barron’s cover story this weekend, “Are Treasury Bonds Safe”, echoes my analysis. When you consider this story occurred nearly a month after I highlighted the trade, subscribers were ahead of the market on this trade. Most importantly, I was able to quantify a possible 9% downside versus a 50%+ upside potential. With such an attractive risk/reward scenario, averaging down was prudent. By staying disciplined and objective, I was able to use a market selloff to turn a losing trade into a winning investment.
Sean Hannon, CFA, CFP is a professional fund manager and weekly contributor for StockTradingToGo.com.