Averaging Down Bull's Pen
by Rick Munarriz ([email protected])

I will admit it, the very phrase "averaging down" sounds lame. Average is average. Down is, well, below whatever average is. This might seem like easy pickings for my fellow Fool, Bogey. Like Jim Jones, he might very well take me out with one punch. Averaging down! C'mon! Why would someone accentuate an investing mistake by adding to a sinking woof-woof stock?

Maybe because, sometimes, the dog is only playing dead. I have yet to find a stock that rose perpetually. Every company, regardless of quality or growth prospects, will find that its shares correct from time to time. Some stocks deserve to be priced down. Not every dog will roll over. Some mutts just can't fetch. Yet when you refuse to take advantage of a buying opportunity when a quality company tumbles because you are tied to a "Cut Your Losses" mantra or cocky to the point that you refuse to accept that you didn't "Buy Low" in the first place, do you know what you're doing? You are passing up on a more attractive purchase scenario than the one your initial due diligence led you to make.

An often used analogy that I think fits here is when falling stocks are compared to either eggs or tennis balls. Eggs, of course, shatter. Tennis balls, naturally, bounce back. Pretty imagery, but is it practical? How can you tell the difference between serving up an ace or winding up with yolk on your face? I would like to think that when quality companies like Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> or Motorola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MOT)") else Response.Write("(NYSE: MOT)") end if %> implode, even the most ardent bear will concede that the stock will eventually bounce back.

Let's not get squeamish in the hunt for those tennis balls. You did your research when you first bought the company, didn't you? Are the reasons still valid? If they are, bonus, you just got a chance to lower your cost basis.

We can't seesaw vanity. We can't be so pompous as to believe that we are buying a company at the exact low and selling at the exact high. It just doesn't happen. On the other hand, we can't be so confidence-shot to assume that if we didn't nail perfection on the initial buy that the investment failure is coated in inertia.

Personally, what I now find myself doing every now and then will probably make Bogey blow his top. When I find a stock that I like, I will buy just half of my intended position. A month later I am in a win-win situation. If the stock is lower and the fundamentals remain the same, I buy the other half -- winding up with more shares for my money. If the story has fallen apart, I can walk away with only half of the losses I would have incurred otherwise. If the stock is higher, I also have a few options. If the fundamentals have improved beyond the share price appreciation, I buy in again -- with my money buying up less shares, but now in a better company with a paper gain already established from the earlier position. If the story has not changed or even deteriorated despite the higher share price, I can cash out altogether or simply not add to the position and ride it out.

Thanks to the ever-widening pool of deep discount brokers this is a cost-effective approach even for people like me with small portfolios. The crux lies in the opportunity missed if the stock rises with just half of your money on board, but this Duel is not about averaging up, it's about averaging down -- clearly, both a lucrative and conservative approach under the lower price scenario.

I am not alone here either. I have Dividend Reinvestment Plans, or DRiPs, in my corner as a way to ease into positions over time. I can also call in the great Warren Buffett, who in his 1997 letter to Berkshire Hathaway shareholders said that if an investor is planning to be a net saver over the next five years, he or she should be happy with a falling market. That's right!

As net savers, we are already averaging into the market as a whole with annual IRA contributions, or weekly 401(k) plan deductions, or by tossing some disposable income into our brokerage accounts. When a stock, or the market, goes down, excellent. If we are long-term investors, then this is opportunity rapping in thunderous fashion.

Investing can be a garden. Sure, pluck the weeds! Get rid of those gangly eyesores. But when you have a wilted flower, man, oh man, water it! Nurture it. Commit to it -- because when it regains its color and sweet scent, the bloom will be all that much more rewarding.

Next: The Bear Argument