Averaging Down Bear's Den
by David Forrest ([email protected])

Never average down! You heard me. Don't ever average down. The process of buying a stock, watching it fall, and then throwing more money at it in the hopes that you'll either get back to even or make a bigger killing is one of the most misguided pieces of advice Wall Street has ever dispensed. I'm talking about when someone buys a stock, watches it fall 10 points (or however much it takes to make you violently ill), and then contemplates the absurd: "Shall I risk even more than I originally intended in a desperate attempt to lower my cost and save my butt?" The answer, over and over again, is a big, fat "NO." Let's take a look at some of the ideas held by investors who average down.

1. If ya liked it at $40, you must LOVE it at $20! This is all well and good except for one thing. Are the fundamentals exactly the same? Chances are the answer is "no." How often does a stock fall 50% without there being something wrong? Not very often. You see, dear Fool, this is the foundation for my belief that you should never average down. The great majority of the time, a stock will fall in advance of bad news. But, because you don't know what the bad news is yet (or even that it's around the corner), you average down, thinking that nothing is wrong. Let's look at three large-cap stocks that have fallen more than 30% in the last year:

Reebok <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RBK)") else Response.Write("(NYSE: RBK)") end if %> -- Down from $50 last July to under $30 right now. In April, after the stock had already fallen from $50 to $30, Chairman and CEO Paul Fireman said in a press release, "1998 will be a difficult year for the Reebok brand due to the generally poor industry conditions in many of our major markets." Ya think?

Sunbeam <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SOC)") else Response.Write("(NYSE: SOC)") end if %> -- Down to $23 from $52 under the management of "Chainsaw Al" Dunlap. The stock had fallen from $52 to $44 before the company pre-announced a loss for the quarter. After the announcement, the stock got creamed even more. Maybe it's Al who should be "chainsawed."

Advanced Micro Devices <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AMD)") else Response.Write("(NYSE: AMD)") end if %> -- Down around $20 after trading at $40 last August. The company has had a miserable 12 months, reporting weak revenue comparisons and earnings losses.

There are many, many more like these. Each of these companies has seen its stock fall dramatically, often BEFORE any bad news hits the Street. Stocks fall for lots of reasons, and one of them is because something has changed in the fundamentals of the company. The problem is that you generally don't know -- until after the stock has gotten crushed -- exactly what the bad news is.

2. Well, all the bad news is out. It's a value now. Really? Have you ever heard of the "cockroach theory?" There's rarely just one piece of bad news, just like there's rarely just one cockroach hanging out underneath your stove. (Pleasant visual, eh?) Chances are, if you shine enough light on the situation, you'll see more. The same applies to Wall Street. Companies report bad news and very often that's just the first in a series of negative announcements. Once the first piece of news gets out, investors hammer the company and scrutinize things even more closely than ever, "shining light" on the situation in the hopes that they'll detect anything else that might be wrong.

3. I'm averaging down so it won't take as long to get back to even on this dog. Remarkably, some people even realize that their stock is a pig (sorry for mixing up my animals!) and they buy more anyway. They're trying to get back to break-even that much faster, and then exit the position without taking a loss. Allow me to give you some advice. There is nothing wrong with taking a loss. You won't win every time, so stop deluding yourself.

Now, I'm sure I'll get tons of notes from people telling me their war stories about how successful they were when they averaged down. They'll tell me I'm crazy. I am NOT saying that people haven't profited from averaging down. I'm sure many have. All I'm saying is that averaging down is a horrible way to manage risk in your portfolio.

Answer this question: Would you rather average down on a stock after it reports bad news and clearly something is wrong? Or, would you like to average UP on a stock after it continues to report good news? Still not sure? Okay, let's ask a different question. In the spelling bee, do you bet on little Sally with the "A" grades in school, or Johnny, your "D" student?" Sally keeps kicking butt each quarter with great grades. Johnny is consistently underperforming. Is it just a matter of time before Johnny comes back and gets those "A"s? Or is the better bet Sally, the solid, consistent performer who keeps giving her parents good news each quarter with a great report card? Of course, the answer is Sally.

Finally, there are going to be some people who say, "I know this company inside and out. Yes, I bought it at $40 and it's now $25, but the market is wrong." Maybe you're right, who knows. Isn't it smarter, though, to wait for the stock to come back above where you bought it to be vindicated? After all, if you bought it at $40, clearly you expect it to go higher than $40. In the meantime, look for a different stock, learn a different company's business, and see how that works out. Don't chase losing positions.

Next: The Bull Responds