Dennis Gartman, famed author of the
Gartman newsletter, claims that the worst mistake an
investor can make is averaging down on a stock. He tells his
readers that when a stock moves higher, that's the time to
average in or average up. In January 2008, Gartman told the audience at
the Toronto Financial Forum that America had entered a
recession, probably in late 2007. In early 2008 he was short
stocks like Google and RIM and was long Gold, Agriculture
Commodities and Bank Stocks. Gartman has mentioned a number
of times that top traders, such as himself, will be wrong 60
to 80 percent of the time or more. He believes that it is
important to sell quickly when it is apparent a trade is not
working out. He believes that when a trade does work out,
the investor should buy more as the stock is moving in the
right direction.
This is also the basis of Vector Vest. Dr.
Bard DiLiddo uses a momentum approach to tells investors
when to buy stocks. His momentum indicators then tell him
when to sell those stocks as momentum turns.
So what is the best approach to take?
In a bull market the
opportunity for gains on most stocks is much greater. There
is some truth to the saying "a rising tide lifts all"
stocks. In a bear market, devastating losses can result as
panic selling can drop stock values by 50, 60 or even 90
percent or more as we saw in fall 2008 and again in March
2009. Companies like AIG fell from $493.00 to around
$6.00. In Canada stocks like Manulife (MFC) fell from $40.00
to $9.02. Literally trillions of dollars have been wiped
out.
The problem for most investors
is not knowing when to sell their "winning" stocks.
Therefore when a stock turns down most hold on hoping for a
recovery and then they convince themselves they will "sell
to get out". I believe there is a better way, depending on
the stock selected, to recover quicker, move back to a
profit position and then decide whether to "get out" and
seek a different stock. To do this I have learned to combine
options - namely covered calls and naked puts to assist me
in averaging down in a losing stock in order to generate a
positive return. But for this type of averaging down
strategy to be successful I have developed 7 rules which I believe
must be followed.
Here are my
7 rules
I follow for when and how to average down in stocks:
1) The most important rule is stock
selection. Stocks have to be large blue chip companies with
strong dividends, solid balance sheets, low P/E ratios, good
cash flow, low debt levels and reasonable payout ratios.
This may seem like a tall order, but there are many of these
stocks available.
2) Set reasonable guidelines as to the
quantity of stock and dollar amounts you want to invest in
any one stock. 15% of your total stock portfolio in one
stock is probably more than enough for most people.
3) After setting your guidelines as to the
amount of stock you wish to purchase, average into that
quantity over time, to take advantage of pullbacks. If not a
Canadian retirement account, average into stocks through selling
naked puts.
4) Use the selling of puts to generate
income while waiting for a decline in stocks. Consider
laddering your naked puts if required in order to keep to
the strike point you originally selected. For example if you
wanted to be in a stock at 30.00 and the stock rises to
45.00, you may have to go out 6 to 12 months to continue selling
naked puts at the 30.00 strike. Remember that stocks move
around a lot more than analysts might have you believe. A
sudden run-up in a stock can be followed by just as dramatic
a downturn.
Pick a handful of blue chip
stocks and paper trade them for a while. Plot each move up
to a new high and see how often that new high is accompanied
by a sell off. This is a common situation as traders
accumulate stock and then when a new high is reached they
sell on the new high. The following day or two the stock
pulls back and these same traders load up again on the same
stock. When another new high is set, they again sell their
shares on the day of the new high. Yet another sell off
ensues and once again these same traders buy the stock. This
is a repeat pattern that is common on stocks. The stock is
in a definite uptrend, but traders are making returns off
each new high. Don't be the investor who buys on the new
high. Wait a day or two and be among the traders who buy in
the sell off. By paper trading a handful of quality blue
chip stocks you will gain insight into the ways of the
traders and learn when to buy and why you should never
consider buying on a new high day.
5) If your stock declines dramatically,
research the stock to determine if the fundamentals have not
changed. If they have not, you could consider rolling down
your covered calls and going further out in time. You can
also consider placing a collar on your stock. (I will post
another article on collars shortly). Try not to sell below your
cost basis however which can lock you into a loss situation,
but as you will see in my two examples, I have often sold
below my cost basis to work my way out of a losing trade.
6) I believe in keeping 30% of my
portfolio in cash instruments in case my stocks should
decline or a new opportunity presents itself. If you examine
my
Royal Bank trade
or my
Sunlife
trade, you can see that my returns hinged completely on
being secure in the belief that I could average down and add
to my position as the stock declined. If I had not been able
to do this with confidence, then my return would have been
greatly reduced. So while Sunlife and Royal Bank saw
dramatic declines along with other financial stocks, the
fundamentals of both companies remained solid, making the
decision to average down, easy.
