Averaging down - A bane or a blessing in disguise?

Now that I have purchased my first 5 lots in CapitaCommercial Trust units @ $1.95 per unit late June 2008, I waited for a few weeks until the unit price descended to hover between around $1.80 to $1.85 per unit range. I recalled the price held strongly over that range for a few weeks, and I got impatient and bought two more lots around $1.83 per unit price hoping to average down my unit average holding price. I thought that averaging down was a good way to increase my amount of units in CapitaCommercial Trust and decrease my average unit holding price. Averaging down does provide these two benefits especially if the investor is convinced after analysing that a company's shares is worth further investment that he should rightly buy even more shares at a lower price.

However, averaging down has its loophole depending on the manner in which it is conducted. Firstly, averaging down does not work on an impatient investor. My situation was that I was too impatient and my next lower purchase price ($1.83 per unit) was simply not much attractively priced compared to my earlier purchase price ($1.95 per unit). Though averaging down can work, but I could not get it to work harder for me as I did not use this strategy properly. I landed up with even more units (7 lots) held at average price of only $1.9157 per unit after averaging down (compared with my earlier holding price of $1.95 per unit). So much for wasting my money in brokerage transaction fee and locking up more money into more units bought.

Secondly, the stock market was still in descent in July to August 2008, so the probability of the unit price going further down is very high. By averaging down, I was in fact repeating my earlier mistake of catching some more falling knives. Indeed, the unit price continued its descent further to come close to $1 per unit range by October 2008. Before October 2008, I made further purchases around $1.60 price per unit and $1.37 price per unit, and finally gave up getting tired of catching some more falling knives. It was a really gruelling and horrible experience of averaging down for me.

Due to my inexperience back then using the averaging down strategy, I suffered the consequences. It was also during that period of time that I came to know about technical analysis as the alternative approach to fundamental analysis for timing entry and exit into a particular stocks. Many technical analysts back then would tell of the dangers of entering the market because all technical indicators point to strong continued descending price action. Actually on hindsight, it was also not difficult nor mysterious to tell that the market is going on a bear descent even for a layperson. Had I been more patient and less emotional, I would not have made further purchases in the name of averaging down to my disadvantage.

It was much later that the unit price of CapitaCommercial Trust continued to decrease further until around the range of $0.60 to $0.70 per unit during March 2009. On hindsight, if I had been patient, I would have bought significantly more units at such low prices and my average holding price during March 2009 would be around $0.95 per unit assuming 20 lots were bought @ $0.70 per unit and adding in earlier 5 lots @ $1.95 per unit. So much difference in bringing down my average unit price from $1.95 per unit to $0.95 per unit. Of course, one can argue that had I waited even more patiently until March 2009 to buy all 25 lots @ $0.70 per unit, I would be even much better. My answer to this statement is that "I am not a prophet nor fortune teller, so do not assume I can do that."

Discussion points:- Averaging down needs to be used properly and can work in two unique situations.
First:- The investor knows a company is worthy of continued investment after careful analysis. He has an initial holding price of the company shares that is already undervalued (below the intrinsic value of the company shares). Upon further descent in share price below his initial holding price, he is in fact purchasing even more undervalued shares of the company. However, if the company share price is beaten down because of permanent problems with the underlying business, an investor should exercise extreme caution because the lower share price may ultimately mean shares having no value instead of undervalued.

Second:- Averaging down does not work on a prolonged sharp market descent (prolonged bear market or recession) because prices are free falling. Instead, an investor should be waiting patiently for the perfect pitch (waiting for prices to stabilise after the sharp fall which does not usually happen in a few days or few weeks, but may take months) before purchasing more shares to average down only at the best opportunate moment.

More on the concept of "Waiting for the perfect pitch" or "Betting heavily at the only best moment, otherwise it is always better to do nothing" in later post..........