One rule that many momentum investors follow is to never average down. The thinking is that if a stock isn't going up and proving that it is strong, then we don't want to add more. Jesse Livermore, considered by some to be the greatest trader ever, once wrote: "Let me urge you to avoid averaging down ... Why send good money after bad? Keep that good money for another day. Risk it on something more attractive than an obviously losing deal."
On the other hand, the methodology of many big fund managers is to reduce their cost basis in their favorite stocks when they have the opportunity. Jim Cramer is a fan of this approach, and will often write about taking advantage of pullbacks in his favorite names.
The primary difference is that the momentum investor is focused on price action, while the fund manager is relying on his fundamental research. The momentum investor believes that the market may possess some insight about a stock that he is missing, while the fund manager tends to be confident in his research and valuations.
Neither approach is inherently superior. What works best is a function of execution, rather than theory. Every market cycle is different.
The approach you should employ depends on your particular style. What is most important is that you have a predetermined plan. The main problem with averaging down into a position is that it is often done emotionally and without a clear plan. Nothing has wiped out more traders than averaging down too big and too fast into a stock.
Even if you are a technical trader and favor a momentum approach, it can make sense to average down if a set strategy is employed. I will often establish an initial position with a view of building on it as the stock moves around on normal volatility. The idea is to catch a larger trend, and you can still do that by building positions by averaging both up and down.
The biggest issue with averaging down is setting a stop level. The inevitable logic is: if this stock was a bargain at $50, it is an even better bargain at $45, and $40, and so on. There must be a time when you admit you are wrong. Money management has to take precedence over fundamental or technical conviction, at some point.
Reluctance to admit a mistake is the biggest stumbling block of all, which is why people like Jesse Livermore are against the averaging down approach.
If you are going to buy into weakness, there are two rules that you must follow:
- Have a clear plan;
- Have a clear stop level.
If you follow those two steps, then market corrections should be cause for celebration, rather than dread.