Having discussed the merits and fallacies behind the principle of pound cost averaging, in my last article I started to look at an alternative method of making frequent investments known as averaging down.
The quick example I gave towards the end of that article outlined the basic principle of averaging down. If a unit price falls below a predetermined limit, further investments must be made so the average cost of the holding falls. The theory suggests that the price does not need to recover to its original level for the investor to make an overall profit.
In this article, I will discuss the workings, attractions and possible problems with this strategy. So let us start with a unit price of £1 at which an investment of £1,000 is made. This means the investor holds 1,000 units worth £1,000. If he sets his averaging down level at 10p, he will buy further units if the price falls to 90p.
A few weeks later, the price does indeed fall to 90p, so the investor pays a further £1,000 for 1,111 units. His holding can be summarised as in Table A.
Having paid an average price of just under 95p, if the units rise even to, say, 96p, the investor has made a profit even though the price has not recovered to its original level.
But suppose, instead of recovering slightly, the price falls further? The investor has determined the trigger points to be at 10p intervals. So if the price falls by10p to 80p, a further £1,000 investment must be made. This puts the investor in the situation shown in Table B.
The average price now being around 89p, it can be seen that the investor only needs the price to recover from to 90p to yield a profit on his total holding.
Without labouring the point too much, suppose the price continues to fall progressively as low as 40p. Table C follows the investor's progress.
The effect of averaging down can easily be identified although it should be noted that the difference between the prevailing price and the average price widens as the price progressively falls. Thus, while initially the price only had to recover by 5p (from 90p to 95p) for the investor to move into profit, by the time of the seventh purchase the price has to recover by 24p (from 40p to 64p) before a profit is made – a rise of more than 50 per cent.
So there are two main areas of caution with the simple averaging down model. First, the lower the price falls, the more it has to recover to move the strategy into profit. This is true in absolute cash terms and, more strikingly, when expressed as a percentage.
Second, most exponents of averaging down fail to note the situation where, far from recovering, the price continues to fall and, in extreme cases, the units become worthless. In these situations, the investor loses everything and will have thrown numerous amounts of money into the strategy.
Can't happen? Many years ago, a friend of mine – actually, the person who brought this strategy to my attention – was a fan of Polly Peck and made massive amounts of money – on paper at least – as the price rocketed from a few pence to many pounds. He cashed in a small amount but then followed the averaging down strategy all the way until the proprietor, Asil Nadir, did a runner and the shares became worthless.
More recently, I am aware of at least two people who have suffered the same fate with certain investment trusts.
It might be worth noting the impact if the investor sets the trigger points at wider intervals. In our example, if the trigger points are at 20p intervals, it can be seen in Table D that very little difference is made to the strategy – simply that the investor does not have to commit quite as much money.
Before I show a variation on this theme, I think it is worth stressing that I am fully aware that few advisers would be inclined to use such a strategy with many clients. However, I know of many advisers who regularly recommend that clients make further investments into a falling fund on the basis that what goes down must come back up. Whether or not the adviser or the client recognises or uses the terminology for that strategy as averaging down, the principle and the effects are still the same.
It is perhaps worth considering a variation which dictates that when the price falls, the amount of the second and subsequent investments are higher than the first. This variation has been borrowed from the gambling strategy known as doubling up and, in its simplest form, requires the investment to be twice as high at each level than the last level.
Thus, if an investment of £1,000 is made when the price is £1, a further investment of £2,000 is made when the price falls to the first trigger point, £4,000 at the next trigger point and so on. Watch the effect on the average price in Table E as many more units are being bought at lower prices.
Impressive, eh? Needs a lot of money, though, and a lot of conviction that the price will recover. I suppose I included this variation more for a bit of fun than a serious suggestion but some readers might be surprised how many investors operate a similar strategy.
In my next article, I will return to retirement income options, with some messages which you might find interesting, informative and surprising.