How I average down (and how not to)
So you have done your analysis on a stock, everything looks good, ie PE, PB, earnings, cf, debt, mos. You buy the stock, and at that precise moment, the price starts to drop. Day by day, it falls. Some up days in-between, but the stock is on a downtrend. After 1 month, it drops by 10%. I think most will try to average down, few will push the decision later when it hits -15 or -20% and some will panic and sell. So what will you do?
For me, I have set a maximum 15% of my portfolio to invest in any one stock. In investment, I feel making lesser mistake is more important than making winner calls. When I buy a stock, the maximum liability is my stake on that stock, nothing more. Why 15%? Well, in worst case that a company total fail, I will lose the 15%. The remaining 85% have to work hard to gain a 20% to break even. If most experienced investors can average 10% a year, it could set me back by 2 years in my investment journey. Which is something I think I can recover from. If there are no change to the company fundamentals, I can decide to average down. It could be in tranches at every 10% drop in price, but the maximum will be cap at 15% of the total invested capital.
To decide if I should average down, I just ask myself this question - will I buy if I have never owned this stock? Simply, take it as a new buy everytime. Use the same judgement call as if I am analysing a new stock. If the answer is no, then I should not buy. Either hold or sell and walk away.
Averaging down just for the sake to gain back the capital that has already been lost is just pure speculation. If I have invested 10k in a stock and it drops to 8k and the fundamentals have deteriorated. 2k may be painful but I should just sell. But if the fundamentals have changed but still not that bad, I can decide to hold, then the max loss is 10k.
But if I start averaging down and buy another 10k, hoping for the best. Now my max lose is 20k. A few more averaging down will amplify the exposure, and soon it will be a bottomless pit. Think of the consequences if this was done for Noble. Just to make back a initial loss of 2k, it could have magnified to a >50k risk.
Also selling just because the price has dropped when there is no change to fundamentals is also not rational. It is just following mr market lead.
This is just for sharing what I will do.