Pyramiding or Averaging Down While Investing

Psychologically, it is far easier to average down than up. But would you know if you are catching a falling knife or a shooting star?

Psychological pricing has worked on humans for a long time because it is always easy to buy a bargain. Say if an item you wanted to buy was put on sale and marked down from $399 to $199, you might be persuaded to get it. And if you saw it priced at $99, perhaps you might be more tempted now. Unlike retail goods, purchasing stocks should not work this way.

Averaging down is a term used when you purchase additional units of shares when the share prices fall lower than the original invested amount. It is always easier to average down because the psychology behind this is that you are purchasing the shares at a discounted price, especially when it plummets far lower than your initial invested amount. This strategy is often favoured by long-term investors who have a longer horizon to help bring down the average cost and breakeven point, thus leading to higher gains in the future if the share prices rebound.

Theoretically, this is an effective strategy, only if the share price rebounds. But if the share price were to continue declining, losses will also intensify and may create doubts to an investor whether to exit their position or continue to average down. It is, therefore, vital for an investor to assess their risk profile and position, which is obviously much easier said than done. More often than not, investors are biased and end up convincing themselves it is a great deal (which is entirely different from purchasing undervalued shares) without reassessing the underlying reasons for the fall of share price.

Pyramiding or averaging up is the opposite of averaging down. Instead of buying more shares in a company when prices fall, you now buy more shares in the company at a greater cost as the share prices are now higher than what your initial investment is. This strategy is a lot more difficult to implement as it acts against human natural reasoning. By doing so, you might think that you are increasing the average cost of purchase, thus creating a false sense of ‘losing money’.

Put it this way, you can never triple your invested amount unless it doubles in the first place. If you want a stock to have a fivefold or tenfold increase, you cannot be afraid in purchasing more as the prices go up. Averaging up in winner stocks can help you get into a larger position, and ensure you have the highest asset allocation in them. By doing so, you can avoid the whole ‘catching a falling knife’ scenario.

I have personally used both strategies while investing and have had various outcomes from it. Some of my averaged down stocks rebounded and gave me a higher return, while some maintained at a low price till this date. It took quite some time to persuade myself that averaging up was the right move and remind myself to trust and ride on the winner stocks.

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