One of the biggest flaws in my decision-making process caused me a lot of anguish and a few losses in the early part of my investing career.

It was the idea of averaging down or buying more of the stocks from my portfolio after they fell from my original buying prices just so that I could ‘average down’ my costs.

The math is simple. Assume you buy 100 shares of ABC Co. for ₹120 per share. Your total investment is ₹12,000. The stock falls to ₹90, because the stock market falls, and you buy 100 more shares. Your new investment is ₹9000. Your total investment is ₹21000 (12000 + 9000) and for a total holding of 200 shares, your average cost now stands at ₹105. You have ‘averaged down’ your cost.

Now, this is not a problem if the underlying business remains good but the stock has fallen just because the overall market has taken a hit.

Anyways, ABC Co. falls from ₹90 to ₹60 because there is a rumour in the market about some mismanagement in the company, but you ignore that. You buy 100 more shares for a total investment of ₹6000. Your total cost now is ₹27000. Your total holding is 300 shares. Your average cost of total holding is ₹90.

You feel happy seeing your average cost come down, from ₹120 for the first transaction to ₹90 for the total of three transactions.

The stock does not know that ‘you’ own it and it continues to fall. Now at ₹40, you buy 100 more shares. The total cost of your entire holding of 400 shares is now ₹31000. So, your average cost is ₹77.5.

This reducing cost excites you a bit, but there is also a ‘sinking’ feeling because you are now holding a large and rising portion of your total investments in this one stock, which is falling.

One day, you get the news that the management has been involved in some shady dealings and the impact is seen in the stock’s price. It falls to ₹20. You are shocked. But you are still hopeful that the situation will get better, and you buy 100 more shares. The total cost of your entire holding of 500 shares is now ₹33000. Your average cost drops to ₹66.

The reality finally sinks in, but it seems too late to have happened. In your pursuit of lowering your average cost and your unwillingness to accept your mistake of owning a bad, mismanaged business, you realize you own a large part of your portfolio in this one stock. Worse, it is still down almost 70% from your lower averaged-down cost of ₹66. Even worse, you must gain 230% on ₹20 to just get back to your averaged-down cost.

You rue your past decisions, but there is nothing much you can do now but rue.

I have been through a couple of such situations in the past, and so as I type this out, I am replaying those situations exactly as they had happened a few years back, and how they hurt my portfolio returns.

The lesson I learned then, and one that has stayed with me ever since is that when I am about to choose between two options, I must only consider what is going to happen in the future, not what happened in the past. The past is over, lost, gone forever. It is largely irrelevant to the future.

In investing, this idea of averaging down your costs is a dangerous idea when you do it just for its name’s sake, that is, averaging down your costs. You may be averaging down your costs of a terrible business or one that is about to get terrible.

Don’t get me wrong here. I would love to buy a great business at ₹80 if I had bought it first at ₹100 or more, and if the underlying business remains as good as when I bought it first and just the stock price has fallen. And I will keep buying such a stock till my idea of the business remains the same (good), and till it remains a reasonable portion of my total portfolio. But averaging down on a bad business just looking at its falling stock price is not something I would indulge in for the dangers it possesses.

Now, this fallacy of averaging down on a bad stock ties very well with the idea of sunk cost, or a cost that has already been incurred and that cannot be recovered. In economic decision making, sunk costs are treated as bygone and are not taken into consideration when deciding whether to continue an investment project in the face of changing ground realities.

Kingdoms have been lost, and companies have failed just because they wanted to keep up with the past and not give in to changing realities.

Just consider this example. You own a restaurant. You have spent a lot of money and time building it brick by brick over the past five years. But it has not done as well as you had initially thought. And now, new restaurants backed by bigger brands are opening in the vicinity, and they are all doing well. You are considering investing another ₹2 crore to do up the interiors of your restaurant, which you know won’t matter much because of the rising competition. You also know the restaurant industry has a high failure rate. What would you do?

Does it matter how much you spent building that restaurant in the last five years? The cost you paid for land and building, cooking equipment, advertisement and branding, employee salaries, etc.? No. Not at all.

What really matters for you is where do you see your restaurant five years down the line. Even whether you can see through the next year or so. Your new investment would depend entirely on that. Not where your restaurant has come from, but where it is going.

Investing in stocks is similar. Your original thesis does not matter if the ground realities have changed. Your original cost does not matter too. Whether you have made a five-bagger on the stock, or it is down 50% from your original purchase price. None of those matters. All that matters is where the business is today, and your assessment of where it may be headed in the next five, or ten, or twenty years.

What’s gone is gone. What lies ahead is what is important.

The costs you have incurred in the past – in terms of money, your time, effort – are sunk. Do not sink in more money, time, and effort on an adventure that looks like failing. You may end up with a white elephant that causes you more trouble just owning it.

Think hard, accept your mistakes, ignore sunk costs, cut your losses, and move forward.

That’s also the way life progresses.

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With respect,
– Vishal

https://www.safalniveshak.com/dangers-of-averaging-down/