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No. of Recommendations: 6
The trick is - when do you increase? At what point? And how much?

My advice here is pretty mundane. Assuming you don't have impact problems (i.e. your capital base is so big that you affect the price with your entry), you don't have much to gain by trying to add to your performance by preplanning an averaging down strategy.

I'm assuming, here, that you don't have any confidence in your ability to predict short term stock movement (if you do, the answer's obvious). On average, it's a better bet that a stock will go up at any point in the future than down, because average stock returns are positive. And if you're buying a stock you think is undervalued, the chances of it going up in the future only increase, at least in your eyes. So when you hold back capital with the intent to average into a position, you're essentially betting that the stock will drop in price in the near or intermediate term, without having a good basis to make that bet.

Instead of intentionally holding back funds with the expectation of averaging down, I invest the full portion of a portfolio I'm willing to commit according to the value I perceive at the time. Say I thought JNJ was worth 100 and traded at $91.45. The 9% or so estimated discount might be superior to 1% of my current portfolio, so that's how much I'd commit. If JNJ drops to $85 without any change in my $100 FMV estimate, I likely will have a bigger amount that I need to move (because my portfolio has more positions with estimated discounts smaller than 15% than 9%), so I add more. And so on.

What happens if, at $91 a share, JNJ provided such an expected edge over the rest of my portfolio that it immediately consisted of 20% of my portfolio, which is my hypothetical diversification-based limit? First, I don't worry about it. It doesn't make sense to hold back on the optimal investment I can find on the hope that it will become even more optimal. Hope is nice, but based on my inability to predict the short term future and on stocks' upward trend, it's more likely that JNJ rises and I miss the chance for superior returns from my full investment. Second, I may become flexible with my diversification requirements to some degree. While there are points of concentration I will not pass, pre-set limits (e.g. 10% of a portfolio in a single stock) are sometimes arbitrary and (if not promised by law or contract to a fiduciary) need not always be enforced to the dollar.

In sum, I think averaging into a position should be based on the relative attractiveness of the stock at a given price as compared to the perceived value in the rest of your portfolio. If you've already maxed out what you're willing to devote to single stock, consider whether the diversification line you set should be firm. But in general, I don't worry about missing out on the short term bottoms of stocks I already hold in cases where I've already maxed out my positions. I'm much more worried about missing out on investing enoughcapital in opportunities I already perceive but don't act fully on because I'm anticipating averaging in. When the stock subsequently rises (as I theoretically expected), it's hard for me to justify (to myself) why I only had 2% and not 8% (assuming that's the appropriate part of my portfolio with lower expectations) in, when everything actually happened as I expected. Of course, one key to this method is to avoid treating all opportunities equally (by devoting a generic percentage of your portfolio), but to put in funds according to the discount you perceive at a given price. That way, you almost inevitably leave room for averaging down if you believe the opportunity arises. Just my approach.



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