I often get the question how to average down stocks when share prices are falling. Today I would like to answer that question by sharing my approach with you. I hope it will help you to avoid making mistakes which I made myself in the past.
But just to be clear: this is not a perfect approach.
I always try to continuously improve myself. But as you know, dividend growth investing is not a one-off execution of a strategy, it’s a journey.
Hence, I hope that you get inspired and that this post triggers your thoughts on how to invest in quality companies when share prices are falling so that fear for losses doesn’t become your bottleneck.
At the same time I also hope to hear about your own approach in the comment section below. Maybe there is something I can learn from you and finetune my approach?
Let’s get started, This is how to average down stocks when share prices are falling 👇
1. Know why you want that company
The best time to do your homework about a certain stock is during relatively low volatile stock markets. But what do I actually mean with do your homework first?
It’s actually really simple. I believe that every investor should be able to say in a single sentence why they want to own a piece of a certain company.
Two guiding questions help me to articulate that:
- What’s the company’s main catalyst?
- Why will that company be much more worth in 10 years from now compared to today?
If you are able to express that then you are actually articulating your hypothesis to own shares in that company.
This hypothesis is very important, because it’s the main determinant to keep your head cool when a stock price is rapidly declining. It’s as simple as that.
Off course, having a price in mind about the fair value of a stock is also important. But this is a bit easier, because if you struggle to calculate this yourself, then you can often take inspiration from other bloggers and financial services like Morningstar.
Though, I would recommend to strengthen your muscle on this and to make yourself familiar with valuation methods like the Dividend Discount Model (DDM) and the Discounted Cashflow (DCF) model. I personally find those the best valuation models out there for us as retail investors.
Last but not least, I assume that you are generally aware about the risks a certain company is facing. A good source for those is a company’s annual report (also their 10K), because they are obliged to list them in there.
Recommendation: go through your portfolio and try to articulate for every company the hypothesis for having it.
You will quickly figure out for which stocks you’re struggling to articulate that. If that’s the case then now is the time to do some further homework so that you are prepared when stock prices suddenly start to decline.
2. Know your limits
The next important step is to know your limits. How many shares of a given company do you actually want to own?
As frequent readers know, I am quite strict in adhering to my own dividend portfolio allocation strategy. It consists of 40 stocks separated in 4 Tiers and this is how I exactly know how much I want to own of a given company
Do you know your limits as well? If not, then ask yourself: Is it 10.000 Euro or 25.000 Euro?
It’s important to me to know my limits.
Adhering to these limits during volatile times prevents me from making stupid mistakes. It’s my own fail-save mechanism, because the least I can count on during a rapid share price decline is my own psychology. It is really about keeping my unwanted roommate under control.
By now I know why I want to own a stock, how much I think its worth, what the risks are and what my maximum portfolio position for this stock is. This means that I feel prepared for whatever happens in the stock market. Let’s now talk about how to average down when the share price starts to fall.
3. Buy in stages
The first step is to buy in stages and not all at once when a share price is rapidly declining. I do this by only buying additional shares after the share price declined another 10% since my last purchase.
But that’s not all. I neither try to buy more shares than 20% of a tier-2 or tier-1 position within the same month.
This prevents me to not get too caught up in the moment by buying more and more while the stock continues to fall. This time component and a 20% constraint is really helpful here.
As an example, the stock market declined really rapidly by almost 30% in a single month last year when the covid-19 outbreak started. Nobody knew how much further stocks would decline when the western world was in the middle of a huge panic attack. As an example, there were literally no cars driving anymore in our otherwise busy street.
At that time we neither knew which stocks were materially impacted for the mid- to long-term. We didn’t have experience yet as society with global pandemics and extreme lockdowns. Hence, it was really difficult at the time to predict which companies where materially impacted forever.
That’s why I believe it’s better to add time-limits into our investment strategy if we want to protect ourselves from losing a lot of money and potential dividend cuts.
Waiting a month before adding additional shares gives me the time to let the stock settle a bit in and to learn more about a company’s resilience to a sudden market making event.
And to be frank, I truly believe that we don’t need to be stock market heroes.
It’s not worth the potential downside risk by going full in into a broken company and lose most of your money that you have worked for so hard.
4. Don’t buy it all, be patient
The second step is to not buy it all and especially when it’s a tier-1 or tier-2 position. I have time on my hand and I rather prefer to see my hypothesis to play out first (see first bullet).
That’s why I prefer to not buy more than 50% of such a position before I have confirmation that my hypothesis is right.
Take as an example Danone. Last year I initiated a position in the company with the main hypothesis that Danone has the right product mix to grow their income in the high single digits by focusing on the healthy-conscious consumers.
At the same time I believe that the restaurant closures due to covid-19 is impacting their water business a lot which is keeping the share price down. I believe that their water business will return to normal once the countries start to reopen again and consumers return to restaurants for the experience of dining outside their own house.
Whether I am right is about to be seen. That’s why I have only accumulated shares in Danone of up to 52% of my total desired position with an average price of €54,98. I truly believe the company is undervalued right now, but I need to see some confirmation first.
And I don’t need to have a 100% position in the stock right now, because I still have 7 years to accumulate the other 48%.
In the meantime Danone reduced their dividend with a meager 8% which leads me to automatically consider selling the entire position. I have done my evaluation and I decided to keep the shares and especially now that the CEO is being replaced.
Having said that, just imagine how it could’ve looked like if we experienced a General Electric scenario here. In that case I would have been forced to sell all my shares at lower levels and take a large capital loss. The good thing is that I would at least have limited my down side, because selling a 50% position hurts less than selling a 100% position.
One of the lessons I learned when reflecting on my mistakes is to always protect my principal first. I know now what Warren Buffett means when he says:
“Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One”.
Luckily I haven’t seen such a General Electric scenario play out for Danone. So what I’m doing now is to patiently wait until the world gets vaccinated and the economies reopen.
At this moment in time I expect the revenue of the water business to pick up again and profits to return to normal. At the same time I want to see that health-conscious related products keep growing in at least high single digits (EDP business unit). Last but not least, I need to see that the incoming CEO will respect the dividend and hike it back in 2022 to where it belongs.
If this plays out, then I will consider to further accumulate the next 48% of my position as long as the share price is undervalued according to my fair value price.
I hope this example clarifies with what I mean to “don’t buy it all”.
PS: what I have described is also sometimes referred to as trying “to avoid catching a falling knife”. This phrase was popularized by Peter Lynch:
“Trying to catch the bottom on a falling stock is like trying to catch a falling knife. It’s normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and settles down before you try to grab it“
5. Average Up
This is actually one of the most difficult steps for me, because I find it so much easier to average down stocks when share prices are falling than to average up.
The reason lies deep inside of me and it is called price anchoring in the world of psychology. I find the description on Wikipedia very resonating with me:
Anchoring or focalism is a cognitive bias where an individual depends too heavily on an initial piece of information offered (considered to be the “anchor”) to make subsequent judgments during decision making.
Once the value of this anchor is set, all future negotiations, arguments, estimates, etc. are discussed in relation to the anchor. Information that aligns with the anchor tends to be assimilated toward it, while information that is more dissonant or less related tends to be displaced. This bias occurs when interpreting future information using this anchor to gauge.
Source: https://en.wikipedia.org/wiki/Anchoring_(cognitive_bias)
This is why I’m really trying to reprogram my mind by making my fair value estimate of the company the price anchor.
But I won’t lie, it’s hard for me,
Most of the time I have this voice in my head telling me that I could’ve bought the shares at a cheaper price. But well, changing behavior and psychology starts with the phase of awareness and I think I’m definitely there already.
Good news though, I have already some proof that I’m getting better at it, because back in January I have averaged up into my 3M position.
But let’s get back to the strategy of averaging up. Averaging up for me is effectively the reversed path of averaging down.
Firstly, I will need to see proof that my hypothesis is playing out.
Secondly, the share price should trade below my fair value estimation.
If both are the case, then the doors are fully and wide-open to make new purchases again. I am also here limiting my purchases to maximum 20% of a tier-1 or tier-2 position within a given month and until I have reached 100% of my target desired position.
This is effectively my approach to averaging up.
Final thoughts
The approach described here is something that I have developed myself based on my successes and failures in the last 6 years. It’s not an approach that I might never change going forward. It really depends on any future learnings I might have.
But you know, the whole mission of my blog is to share my accumulated knowledge in dividend growth investing. Therefore I hope that this helps you to avoid starting at square one.
Last but not least, just let me know if you have another approach on how to average down stocks when share prices are falling . I’m more than happy to learn from other great minds 👍
Yours Truly,
European Dividend Growth Investor
