Finance · Investor psychology
Averaging down makes the loss look smaller
By Prof. Alessandro Buffoli, PhD
The percentage improves immediately. The cash loss stays put, and the position gets bigger.
Suppose I own 100 shares bought at HK$100. The price falls to HK$70. I buy another 100, and my average purchase price drops to HK$85. On the screen, that looks like a repair.
I have still lost HK$3,000. I have also committed another HK$7,000 to the same investment.
| Position measure | Before | After |
|---|---|---|
| Shares held | 100 | 200 |
| Total purchase cost | HK$10,000 | HK$17,000 |
| Average purchase price | HK$100 | HK$85 |
| Current market value | HK$7,000 | HK$14,000 |
| Unrealised loss | HK$3,000 | HK$3,000 |
There is a second improvement on the screen: the percentage loss falls from 30% to about 17.6%. The same HK$3,000 loss is being divided by a larger purchase cost. Neither number tells me that the company’s prospects have improved.
The next move matters more. If the share price falls from HK$70 to HK$60, the enlarged position loses another HK$2,000. The original position would have lost HK$1,000. A rebound would also produce a larger gain. The new purchase increases exposure in both directions.
What is the next HK$7,000 buying?
My objection is to letting the old purchase price organise the new decision. At HK$70, there may be a strong case for buying. I want to hear that case without reference to the relief of bringing the average down.
Thaler and Johnson’s experiments found that, following losses, opportunities to break even can become especially attractive. Averaging down interests me because it moves that break-even price closer. My suspicion is that the visible improvement can make the extra commitment easier to accept. That specific interface effect needs testing.
One useful question is whether I would put a fresh HK$7,000 into this company today if I had never owned it. A second is whether I would choose the resulting position size. The answers require a view about the investment now; my original HK$100 purchase provides no answer to either.
I would put three figures together on the order confirmation: the new average cost, the additional cash committed, and the total position value. Beside them, show the cash gain or loss from the same percentage move up or down.
The average cost can stay. It just needs company on the screen. In this example, seeing HK$85 should also mean seeing HK$14,000 of exposure to the next price move.
The share purchases and price changes are hypothetical and exclude fees.
Prof. Alessandro Buffoli, PhD
Assistant Professor of Marketing at The Hang Seng University of Hong Kong.