40 - When NOT to average down on an investment (Investing Rules)

Mental Models discussed in this podcast:

• Leverage

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Should you invest in Private Prisons? - Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode40

What is averaging down?

• Averaging down is the process of buying additional shares of stock as the stock price declines. 
• This lowers your average price of acquisition for a stock.
• The last time I discussed investment rules was about lessons learned from my investment in GameStop. Today, we focus on new lessons learned from other people’s experience:
• • In particular, Bill Miller and the lessons learned from him by John Hempton at Bronte Capital.

Portfolio Management

Cheaper is not always better when it comes to portfolio management

Three new investment rules

1. Do not average down on a highly leveraged business model.
2. Do not average down on an operationally leveraged business that is declining
3. Do not overage down where the primary risk is obsolescence. 

90% decline vs 95% decline

A stock that is down 95% is not substantially better than a stock down 90%. 

However, they may appear similar when superficially compared. Yet, the additional 50% decline needed to reach 95%, doesn't necessarily equate to a bargain. 

Always avoid going back to zero

• Bankruptcy risk is the primary concern that you are trying to avoid with these new investing rules. 
• Leveraged companies, in particular, have a higher than average bankruptcy risk. 

Summary

Cheaper is not always better when it comes to portfolio management. Once you have hit your investment allocation for a position it can be a mistake to throw good money after bad. Assuming your investment analysis is correct, you will still end up making money. Yet if you are wrong, you will exasperate a bad situation by averaging down on a losing leveraged position.

References

Bronte Capital: When do you average down?

A full list of my investing rules available on DIYInvesting.org