Sooner or later you will ask yourself whether you should add to a losing stock position. The reasoning will be tempting; ‘if it was good at 100p, then it must be better at 80p’. Such lore is especially popular on online bulletin boards.
But stop. This and other trading myths are costly, yet pervasive – they burrow around in online portals disguised as ‘underground investment secrets’ awaiting the unwitting. Read what the professional traders say first and it will save you money.
Take ‘buying more at a lower price’, other variations of this include, ‘pyramiding’. The idea is that by buying more stock as the price falls, you reduce your average purchase price and so lower your breakeven point.
For instance, if you bought £5,000 of Invensys shares at 100p, then another £5,000 worth when the stock halved in price to 50p, the point at which you would break-even moves from 100p to only 66p. It is tempting.
Don’t do it. Trading is not about ‘getting a win’ on any one trade; it is about limiting your losses and maximising your gains over all your trades. If you ‘average down’ then you’re simply less diversified and own twice as much of a company whose price keeps falling. That’s fine if you think it is the best place out of 3,000 listed stocks for your money, bad if you just want to ‘get a win’.
Moreover, novice investors often confuse price with value. I know my wife does when shopping.
A falling price does not mean a cheaper stock. The value of a stock can be measured by earnings, assets it holds, and other ways. A falling price could reflect simply lower expectations of value.
The investor should instead consider ‘in which stock can I best make a return’? It would be great coincidence if the answer is ‘the very same one which has been returning me a loss.’
Another favourite among bulletin boardsters is ‘pound or dollar cost averaging’. It is a sensible idea but overstated. For example, if you had £12,000 that you wanted to invest in a stock, they would tell you to invest £1000 per month over a year, rather than investing the whole amount immediately. The rationale is that you will automatically be purchasing more shares when the price is low, and fewer shares when the price is high.
However, since 1950, dollar cost averaging with the S&P 500 has actually failed to beat investing the lump sum at the start of the year in two years out of three.
Of course, cost averaging will win if your start date falls right before a dramatic crash or at the start of an overall 12 month slump.
Since we are playing with numbers, there are two further tricks the markets play worth remembering.
First is the ‘it’s down 40%, so it only has to rise 40% to break-even’ mistake. If a stock moves down, say, 40%, then it has to rise more, a whopping 66%, before you are back to break-even.
Equally, if the stock moves up 40%, then it only has to move down just 28% for you to get all the way back down to break-even. So a 40% rise does not afford you as much protection from a downturn as you might have thought.
Sadly, private investors often have a fixation for making back their losses in the same stock in which they incurred them.
Mark Twain had the best advice for the investor who, loaded with market myths, becomes overly confident in his abilities: ““April. This is one of the peculiarly dangerous months to speculate. The others are July, October, December, January, March, May…”
By Alpesh B Patel