Can 'averaging up' mean larger investments without greater risk?
If you've not done so yet, I recommend you read my Foolish Guide to Stop Orders before reading this article.
I concluded by promising to show you how to use pyramiding in conjunction with stop orders to increase the size of your investments without increasing your risk. That's what I'll do now, by explaining how 'averaging up' by pyramiding is less risky than the ostensibly more logical pursuit of 'averaging down'.
Averaging Down
If one of your investments falls, do you add more funds to it on the basis that it is now even better value and you are lowering your average purchase price?
How many times would you do this before realising that the stock in question is on a one-way ticket to oblivion? And how many of your perfectly performing investments would you cash in, possibly prematurely, at a profit in order to keep funding this foolish (not Foolish) endeavour?
If you're not careful, averaged-down stocks can become magnets that attract all of your investment funds... just before going to the wall.
When one of my initial investments falls, I am more likely to stop out quickly in a spread betting account in the hope of re-purchasing even cheaper at a later date; and I'm more likely simply to hold in a share dealing account on the basis that, hey, my first investment is only a small one.
Averaging Up (i.e. Pyramiding)
In contrast to averaging down, I consider myself to be on safer ground 'averaging up' by pyramiding additional funds into a rising stock. Well, at least it's heading in the right direction!
Here's a concrete example:
On 26 August 2010, I established a £1-per-point spread bet on Severfield-Rowen (LSE: SFR) at a price of 203.1p, but we can pretend it was a £1,000 investment.
By 29 October my £1,000 had become worth £1,175 (ignoring commissions and the spread to keep it simple), and so I purchased another £1,000 worth at a price of 238.8p.
I'm still holding at the end of this chart, so my original £1,000 is worth £1,398 and my second £1,000 investment is worth £1,189. I have two positions in this stock, each showing a profit, and I now have twice the investment working for me if the price goes ever higher.
If the price had gone down at the outset, rather than up, I could have kept my original toe-hold in this stock for no greater worst-case risk than my original £1,000.
While I limited my initial risk by deploying a minimal position size, and not planning to add to it on the way down, it turns out that I am just as susceptible now to a "black swan" total wipe-out as I would be if I had averaged down.
And that's where my Stop Orders come in.
Pyramiding plus Stop Orders
At the time of establishing my second position at 238.8p, I placed a stop order at 229p on both my original position and my new position.
If the price started to head south, and my positions stopped out, then (assuming the stop order executed as expected) I would have locked-in a profit of £128 on my first position and a locked-in loss of £41 on my second position. I had guaranteed a minimum profit of £87 overall while doubling the size of my investment.
I had increased my investment without increasing my risk.
By the end of the chart my combined investments are valued 'on paper' at £2,587, of which £2,241 is secured by my stop orders now raised to 246p. Best of all... I'm still holding.
Conclusion
I can well understand the allure of 'averaging down'. If the price of a falling stock ever recovers, you make even more money. But if it doesn't, you're in trouble! And in this case my Stop Orders won't save you because you can't use them to lock-in profits on a falling stock.
In all investment matters we should think not only about how nicely our gamble might pay off, but what if it doesn't.
In the pyramiding scenario, we still get to benefit more and more from a sustained recover, but we can never lose more than our original stake. And by using stop orders effectively: as the price goes higher, we can actually make our risk go lower.
You can decide whether this is Foolish, but keep in mind the fact that I have said nothing about why I chose Serverfield-Rowen as a good candidate for investment in the first place. According to this article, Fool writer G. A. Chester might also have been thinking about it around the time of my original investment.
More from Tony Loton:
> With The Motley Fool's Share Dealing Service, you can buy and sell shares in real time for a flat rate of just £10. You can also shelter them in an ISA or SIPP. Open an account for free today.
> At the time of writing, Tony Loton had a spread bet position in Severfield Rowen.
