Is Averaging down like Catching a Falling Knife?

You have to be smart to do it, but you can average down safely.

falling knives
Can you really catch falling knives?. Niko Guido/Vetta/Getty Images

There are certain sayings about investing that are beyond question.  "Don't invest more than you can afford to lose," comes to mind.  Who would argue with that?

"Always do your own research," is another adage that you would be hard pressed to disagree with.

But what about "Never average down your losers?"  On its face, it seems to make sense.  And great investors from William O'Neil, the founder and publisher of Investor's Business Daily, to Paul Tudor Jones, one of the original Market Wizards, have repeatedly affirmed this rule.

But is it really true?

Recently my friend Frank Zorilla wrote a post in which he showed that PTJ not only averages down, but does it rather frequently. How can someone break what is seemingly an immutable stock market rule and still become one of the greatest traders/investors in history?

First, we have to look at what it really means to "average down" in a stock.

Traditionally it means to add to a current position after it has moved lower, the idea being that those lower priced purchases will continue to bring your overall cost basis down, requiring less of a move up before you get back to profitability.

The problem with this technique is that often stocks that are moving lower are doing so for a reason. The market is littered with the ruins of traders and investors who kept adding to positions as their stock went lower, waiting for the rebound that never came, and going broke in the process.

Frank postulates a couple reasons averaging down might have worked for PTJ...

Maybe now he believes in the strategy, maybe due to the amount of money he manages he has no choice, or maybe the market has changed from when he first said the quote that averaging down maybe is now a prudent strategy for him, who knows.

Those are all definite possibilities, some or all of which may or may not be true.  But I can tell you a way you can average down with some degree of safety.

At any given point, a stock can be in various trends, based on different time frames. These are usually broken up into short, intermediate, and long-term trends.  Often these are determined by moving averages such as the 20, 50, and 100, or alternatively, the 50, 100, and 200.  

This means that a stock can be moving down in one time frame or trend, but still be moving up in another, longer term one.  So technically, you could buy a stock that is dropping in one time frame while still up in another.

So......

If you wanted to average down in a stock you owned, which you thought was still solid, the best (and safest) way to do it would be to buy when one time frame intersects with another.  For example, your stock is going down in the short term, then you could buy it when it hits the 100-day moving average, the intermediate term.

Or, you if the stock is going down in the intermediate term, you could buy it when it hits the 200-day moving average, the long-term.

By using these objective criteria, instead of "catching a falling knife," you are approaching the process in a responsible way, using solid risk management.