Don’t Succumb To The Averaging Game

A successful self trader – Rule # 22

Averaging is the cardinal sin of investing

Let me begin with the caveat that, averaging your position is not theoretically wrong. Just that it does not work in practice. You bought a great stock, the stock corrected; you averaged and lost money. You averaged your short position and again ended up with losses. Why does averaging not work in reality? Are there situations where averaging makes sense?

The legendary trader, Jesse Livermore, used to call it the involuntary investor syndrome. It happens to most of us, most of the time. Let us say we buy Tata Steel at Rs.500 and see the stock go down to Rs.450. Our immediate reaction is to buy more of the stock, considering its history and pedigree. Livermore says that in this obsession, a trader becomes an involuntary investor.

One of my investors gave me the example of how averaging worked perfectly for him. He started averaging L&T at Rs.1800 a couple of years ago and kept buying all the way down to Rs.700. Today he is sitting on a neat profit. Those who are impressed, should remember

Keynes, “Markets can be irrational, much longer than you can remain solvent.” And therein rests the catch!

 3 REASONS AVERAGING WILL NOT WORK FOR YOU

 You always trade with finite capital

 Nobody started trading with a blank check. You have a limited capital outlay and therefore there is only so much risk that you can assume. Allocating that risk to averaging is a waste of capital. Surely drowns you!

 Why commit the same mistake twice?

 When you buy and the price goes down, it means you were wrong. Averaging is being wrong twice. There is probably a message from the market, which you missed the first time. Don’t try to be second time lucky!

 Never put all your eggs in one basket

 The biggest risk you run in the market is putting all your eggs in one basket. Warren Buffet may have made all his money in a handful of stocks, but he was an entrepreneur not a trader. As a trader, always spread your risk!

“Never ever try to meet a margin call; just get out of the trade” – Jesse Livermore

5 SITUATIONS WHEN AVERAGING CAN BE DANGEROUS

  1.  As I said in the beginning, averaging is conceptually flawed. But averaging can be deadly when you have missed a pivot point, either in the market or in a stock. If you bought index futures when the market was at 30 times P/E and a VIX of 40, don’t commit the blunder of averaging. You have already made the mistake of buying a pivot, instead of selling it!
  2. Don’t ever try to average out-of-favour sectors. It always happens to quality stocks in sectors that have outperformed for too long. Capital goods in 2010 were a classic example as traders kept averaging without considering the slowdown in the capital cycle. Banking in 2010 was another case of a good sector bogged down by NPAs. Averaging would have been foolish!
  3. Remember the basic rule, “Cheap crap, is crap anyway”. Don’t try to average a stock that is fundamentally a dead duck. Averaging Himachal Futuristic or Pentamedia in 2001 would have been meaningless. They were shells anyway. Imagine doing the same with a Kingfisher and Deccan Chronicle in 2013? Price is immaterial in such cases. They are just empty shells!
  4. Averaging a futures position is a cardinal sin. Let me explain! A futures position is leveraged. When you pay 20% margin, your exposure is 5 times. When you average it once, your exposure becomes 10 times. You need to understand that when you have a 10 times leverage, a negative price movement of even 5% is enough to wipe out your capital; and a lot more.
  5. When there are extraneous factors at play, averaging can be deadly. How do you recognize such factors at play? You obviously cannot, but listen to the market message. Remember the trader who kept shorting ACC in 1991; not knowing that the buyer had access to free funds from dubious sources! After squeezing the seller, ACC eventually tanked. Too late for the trader, though!

FAMOUS DISASTERS RESULTING FROM AN OBSESSION WITH AVERAGING

 Some of the biggest global market bankruptcies happened because of averaging out a losing position. In 1998, LTCM kept averaging assuming that the bond spreads will eventually return to equilibrium! By the time they did, LTCM had gone bust. Nick Leeson kept averaging his positions on the Nikkei, betting on a return to normal. The Kobe earthquake was the last nail, as Leeson took the 200 year old Barings down along with him.

Same was the case with Lehmann too. In all these cases, they persisted on their own flawed reasoning, without listening to the market! The most famous case, where averaging worked, was of John Paulson who kept adding to his short position on US sub-prime for a full 2 years. It was the most successful trade in history, but it is anybody’s guess what would have happened to Paulson if the sub-prime euphoria had persisted for another year. Remember, Paulson is a case study not a template.

TAKEAWAYS FROM THE “AVOID AVERAGING” DEBATE

 Dennis Gartman, editor of Gartman Newsletter, rightly says that averaging is eventually a losing position. It is like assuming that you can become subsequently right by being wrong twice. The basic philosophy of trading that one needs to follow diligently is, “Being wrong once is human, but being wrong twice is asinine”.

The greatest trader, Jesse Livermore, aptly said, “Markets are never wrong; opinions often are”. When an index or stock is going against your view, it is actually giving you a message that you are missing out on some important facet of analysis. Be humble enough to listen to this message and modify your trading strategy immediately. Please don’t respond by averaging!

You can ask us your stock related questions with#AskReligareOnMarkets via our Twitter channel @religareonline

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