How to win at the investing game – discipline!
In school, I hated essay questions! They made me uneasy, panicky, and unpleasantly sweaty. The biggest problem I had with essay questions was wondering what the professor was really looking for. In the end, I’d always end up over-analyzing the question instead of just putting down what made sense.
Many moons ago, I was filling out a job application and I came across a non-typical, hypothetical essay question that threw me for a loop. The question was, if you could have just one superpower what would it be?
Once again, over-analyzing, I thought to myself, “What kind of answer are they looking for? If I write down something like flying, would they think I’m unstable and flighty? Or what if I choose super strength, would they assume I had a strong personality, am very demanding, and would have trouble taking orders from management?”
After struggling for a few minutes, I answered, that if I could choose one superpower it would be having the ability to see into the future.
In all honesty though, that would actually be a horrible trait to possess, as not only would you see the good things to come, but also the bad. However, it sure would come in handy for knowing which stocks to buy and at what price to buy them.
Since none of us have the luxury of a crystal ball, knowing which stocks to buy and at what price is a challenging decision. For a moment, let’s focus on a widely debated strategy called “averaging down”, and how it can help you maximize your returns by becoming a better shopper on Wall Street.
The strategy of “averaging down” is simply, buying more of an investment at a lower price. For long-term investors, it can be a very effective way to get a great investment at a lower average price and get more shares for your buck.
But before we go any further, let me stress one very important point – averaging down is a strategy that should only be used on above average stocks. If you have any doubts about a particular investment you are about to buy more of, then you shouldn’t proceed, because it is highly likely that you may just end up owning a larger stake of a losing investment. And this can be very damaging to your portfolio – so please only average down on absolute, for certain dream buys.
The best way to demonstrate the potential long-term benefits of this strategy is to give you an example. So, let’s say after researching a company to death, I calculate an optimum buy price for the stock is $8 per share or less. I also decide beforehand to make 3 separate investments of $1,000, at $8 per share or less, for a total cost of $3,000.
After a few months of following the stock, my dream comes true and the stock price finally dips to around $8 per share and I make my first $1,000 purchase of the stock. The stock starts to rise and appears to be making a nice run-up. Yet I stick to my guns and don’t buy any more shares. A few months later the market goes through a major correction and an amazing opportunity presents itself, as I am able to purchase another $1,000 worth of the stock at $5 per share.
Thinking I got an incredible deal and I’ll never see these levels again, guess what I do. Less than two months later, I make my third and final $1,000 purchase at $3 per share. Time goes on and the stock starts to trend lower again, but I don’t panic, I’ve done my research and I’m holding this one for a minimum of three years – given any unforeseen catastrophic events.
Here’s the beauty of averaging down
Now let’s assume you buy just one lot at $8 per share for the same total cost of $3,000. The difference between this scenario and utilizing the strategy of averaging down can be seen in the table below.
By averaging down, you pick up a lower average price per share of $5.33, the one purchase scenario, and you gain an additional 283.33 shares – nearly 75% more shares for the same total cost. Now if the stock rises to $8 per share, by averaging down we hypothetically made $2,266.64 in profit by averaging down versus coming in at break-even if we would have made just one purchase. In addition, at $10.66 per share we could potentially sell half our shares to recoup all our costs for the initial purchase and be riding on free shares.
Yes, I know this is just a hypothetical example. But I can tell you for certain, the strategy of averaging down on high quality; dream buy stocks will produce amazing results. The key here of course is the phrase “high quality, dream buy stocks.”
I can’t preach enough about this – do not average down on anything but high quality stocks! Even if the stock looks insanely cheap compared to your original purchase, trust me, if the company is not firing on all cylinders then it will likely get even cheaper.
In all honesty, the price that you pay for a stock may not matter all that much over a 10 to 20 year period. Your focus should be on, first and foremost, the potential future of the company, and then if it passes stringent research, focus on the price.
I always say, “in this business it pays to be a good buzzard.” Once you have your prey spotted, keep circling, because more often than not, a good buy will eventually turn into a dream buy. And hey, who says you can only fly down for one feeding!