The issue of whether to average down on cheap FTSE 100 shares is hotly debated among investors. Right now, some classic blue-chip stocks are much cheaper than they were before the stock market crash of March. Does it make sense to buy them now, at a lower price? Or should you cut your losses and run?
Let’s consider first what it means to average down. It’s a contrarian investing method used to great effect by multi-billionaire Warren Buffett. He is regarded as the greatest self-made investor of all time.
How to average down
Simply put, it means to buy more shares in a FTSE 100 share you already own, at a lower price than you have paid before.
Say for example you own BP shares. In 2018, you would have paid around 500p per share. In May 2020, the market only values BP at 300p. That’s 40% less than two years ago. Has the true value of this FTSE 100 giant really fallen 40% in 24 months? Absolutely not.
In fact, the energy supermajor is one of the best cheap FTSE 100 shares you could buy today, in my view. BP currently pays a large 10.4% dividend yield, while so many others have slashed or suspended dividends entirely. I’ve also covered how its massive renewable energy investments mark it out to me as a major winner in the future economy.
But if you buy BP shares now, the average price you paid for them has fallen to 400p. Congratulations! You’ve just averaged down.
And if you choose the right investment in cheap FTSE 100 shares, you up your chance of making more money over the long term.
The intelligent investor
This phenomenon was described by Benjamin Graham in his seminal 1949 book The Intelligent Investor. Graham proposed the idea of Mr Market as an allegory for the stock market. He is a character who suffers extreme mood swings. His pricing is irrational because it is emotional. Sometimes Mr Market will give you a chance to make money by undervaluing some shares and overvaluing others.
Warren Buffett described reading The Intelligent Investor as one of the most important events of his life. He jumped at the chance to take Graham’s class at Columbia University in 1951. Graduating at the age of 20, Buffett went to work in Omaha selling securities. Over the next four years, he begged Graham for a job, eventually joining him at the Graham-Newman Corporation in 1954.
Some 55 years later, the Berkshire Hathaway CEO is worth in excess of $68.5bn.
Don’t average down?
There are, of course, instances where you should not average down.
When used incorrectly, it is symptomatic of investors throwing good money after bad. This takes the form of spending vital cash on an underperforming company whose revenues, profits and earnings per share are falling.
In this scenario an investor’s burning desire to be right short-circuits logic and overtakes the need to make money on an investment.
But the lesson I learned from Benjamin Graham and Warren Buffett is this: resist market hysteria and use it to your advantage to get bargains in cheap FTSE 100 shares that have true long-term potential. And — in the case of BP — picking up a 10% dividend yield a year on top isn’t bad either.
Tom Rodgers has no position in the shares mentioned. The Motley Fool UK owns shares of and has recommended Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short June 2020 $205 calls on Berkshire Hathaway (B shares). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.