Something that is well known to value oriented investors is the concept of averaging down. It can be something, if used correctly that can really add to returns over time. But as with anything it’s a dual edged sword.

You can do one of three things when the price of your stock goes against you. (1) you buy more, thus averaging down. (2) do nothing , (3) sell.   (1) presupposes that you have money to buy more, which is why its a good idea to average into and out of positions.  From my own experience , when you find a good idea, that seems undervalued, there is a temptation to buy as much as possible immediately. This should be resisted, in my experience sometimes a value gap closes quickly right after purchase (usually a catalyst was involved). More often then not though, the price will move against you for a period of time. This makes sense, because if you think about it the kinds of stocks we are interested in are ones that have been neglected for some reason. This usually has some momentum to it, it takes time to change the investing public’s perception.

If you do nothing, then you are going to wait for the value gap to correct, collect dividends if the stock pays one, and continually assess and reassess that the story remains intact, and there wasn’t a fundamental flaw in the analysis. As a general rule if a position moves against me by 20% or more, I will completely reevaluate it, to make sure there wasn’t something that I missed. If I’m satisfied that nothing fundamental has changed with the thesis, then I will continue to hold. A usual holding period for me is 2-3 years, sometimes much shorter depending on how long it takes for the valuation gap to close.

If you sell then you are either admitting you were wrong about something in the initial analysis, or something fundamental changed about the business. This is ok. I have saved myself much pain, by admitting mistakes early. The key is to redo the analysis, think it through again. Don’t delay this, as a group value investors seem to be more content to sit on a loss, and it’s ok as long as the thesis is intact. No value investor, likes a permanent loss of capital, it violates the first two fundamental rules of investing (for Buffett fans). Taking a loss is where the humility factor comes in, you have to be humble enough to admit a mistake, learn from it and move on.

In contrast to the sell decision is the decision to average down. This is in essence one of the most powerful techniques available to the value investor to increase returns, outside of leverage. Averaging down requires the conviction of your own analysis  and a deep understanding of the value of what your buying. In another words you have figured out ahead of time, what the entire business is worth, you already bought at a discount to that, and now your buying a bigger discount. This is where risk and return are paradoxically inverse to one another. You have less risk because there is a bigger margin of safety, but there is a higher possible return because the value gap is larger.

Of course if your wrong about the price, then you will be guilty of throwing good money after bad. You will magnify your losses. So it’s critical to be dealing with a business you can understand and value with a range of possibilities that favor gain.

I have been averaging down on several things lately. Some of the largest value gaps I’ve seen since 2008 have appeared in some of the stocks I own. The last 2 years have been fairly tough for value oriented investors, but we will have to see how 2016 goes.