Averaging down: Why it's a trap

Averaging down involves buying more assets when their price drops, hoping to lower the average purchase price. Example: You bought shares for 10,000 PLN at a price of 100 PLN per share. The price drops to 90 PLN, so you buy more for another 5,000 PLN. Now you have 150 shares at an average price of 96.67 PLN, but the price continues to drop to 80 PLN.

• Error 1: Assuming the price will bounce back. Markets are unpredictable.
• Error 2: Lack of an exit plan. People often do not have a stop loss set.
• Error 3: Ignoring transaction costs. Each transaction incurs additional costs that further reduce profits.

Averaging down is problematic because it increases risk and losses instead of minimizing them. It may seem like you are lowering your average purchase price, but in reality, you are investing more money into an increasingly risky position.

• Martingale mechanism: It's like playing in a casino, where you increase your bet after each loss in hopes of recovering everything.
• Slippage and spread: Even if the price rebounds, slippage and spread can prevent you from recovering your investment.

Assume you start with a capital of 15,000 PLN. You buy shares for 10,000 PLN at 100 PLN each, but the price drops to 80 PLN. You buy more for 5,000 PLN, raising the total investment to 15,000 PLN with an average price of 93.33 PLN.

• Scenario 1: The price drops further to 70 PLN. Your shares are now worth only 10,500 PLN. The loss is 4,500 PLN, which is 30% of the capital.
• Scenario 2: The price rises to 85 PLN. Your shares are worth 12,750 PLN, but you are still down by 2,250 PLN (15% of the capital).

To avoid the averaging down trap, follow the guidelines below:

• Define an acceptable loss level and set a stop loss.
• Invest only a portion of your capital in a single transaction, e.g., 5-10%.
• Consider hedging strategies like put options.
• Analyze the market and be guided by facts, not emotions.
• Regularly review and adjust your investment plan.

Set automatic stop losses in every transaction to protect capital.