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I read a very interesting article by Seeking Alpha contributor Dr. Kris that argued that 'averaging down' into a speculative investment with deteriorating fundamentals is a "bad investment strategy." I agree wholeheartedly that buying the case study example, Deckers Outdoor (NYSE:DECK) based on the fact that it was a "market darling" was a poor investment. This poor investment was further compounded through averaging down. I also would agree wholeheartedly that buying houses in 2007 was a "poor investment," but I wouldn't necessarily follow that insight to publish an article titled, "Real Estate is always a Poor Investment."

How to Prove (or Disprove) the Merits?

Through evaluating the comment stream, it appears that I wasn't alone in my thoughts. Hindsight bias is always 20/20. How can I counter that without also instituting extreme hindsight bias? Let me think back to great case studies of averaging down. Ford (NYSE:F), yes! General Motors (NYSE:GM), not so much... Recent personal successes include Aeropostale (NYSE:ARO), Sprint (NYSE:S), and Body Central (OTCQB:BODY). If I include those, it's only fair that I mention that I started my Nokia (NYSE:NOK) position just under $7 with a current average cost-basis of just under $4. Ouch! Maybe Dr. Kris has some solid points here?

A Defensible Position

In order to satisfy all constraints, and armed with significant historical market research, I have reached a conclusion. I will write an op-ed with my conclusion: "Averaging down is a great strategy if the stock will eventually recover." After I gain worldwide recognition for my genius, I will release my book, aptly titled: "Avoid Averaging Down in Stocks Destined for $0." Following literary success, I may seek a career in politics where I use hindsight to dissect every decision of my incumbent opponents. Pretty silly how President Clinton, President Bush, and Greenspan pumped that "obvious" housing bubble right? But I digress; sarcasm is indeed the protest of the weak.

Moving Forward - Let's Align Our Definitions

I think a primary misconception exists between the uses of 'investing' and 'trading/speculating':

If you're investing in the stock-that is, you're viewing this as a trade and not a long-term investment-then averaging down is a strategy that runs counter to your goal of making a profit.

If you are trading purely on momentum indicators, then this makes sense. I would argue that investing purely on momentum indicators is a horrible idea as well. Ask NFLX and ZNGA shareholders who bought in on strong momentum how that turned out for them.

The situation may be different, though, if you're investing in the company itself. If, after doing your homework, you are convinced that the company is a good value and you are planning on holding the stock for a long time, then averaging down may work to your advantage. The operative word here is 'may.'

It's only investing in my opinion if you are investing in the company; stock price technical indicators alone are pure trading/speculation if you ignore the underlying company. "May" is a very loose word. Interesting that the title of the article includes the definitive "is." I wouldn't have responded quickly to an article titled "Why Averaging Down may be a Poor Trading Strategy."

Even if you're convinced that management is on the right track and the fundamentals are solid, I still have a bias against this approach for a couple of good reasons. One is the fact that hype and circumstances can blind even the most judicious, rational investor. Previous Federal Reserve Chairman Alan Greenspan dubbed this condition "irrational exuberance."

Remember the dot-com bubble in 2000 when Internet stocks were bid up to frighteningly high valuations? How many of them are in business now? and were two Internet darlings that quickly flamed out once the bubble burst.

Or what about accounting scandals that were kept so hush-hush that even top Wall Street analysts were fooled? Think Enron, Tyco, and WorldCom-companies that wiped out many a retirement account.

Alan Greenspan was referring to the belief, by some traders and investors that prices and other market valuations could increase indefinitely. and never had solid fundamentals, similar to how Groupon (NASDAQ:GRPN) never had the fundamentals to justify its stock price. These equities were purchased as speculative trades, in the hopes that some "other sucker" would pay more.

Enron, Tyco, and WorldCom had decent growth figures and impressive profits for a few periods; however, they also traded at an "irrational exuberance" premium, and several warning signs emerged before the stocks collapsed. I find it hard to believe that many investors 'averaged down' into these companies based on a legitimate belief in value fundamentals.

Nit-Picking Aside

Point-by-point rebuttals can provide a good debate, and it's important to insure that definitions are understood, but the thrust is to provide an argument in favor of averaging down on a strong fundamental investment. Ford provides a great story, but their fundamentals mixed with the current economic environment pointed towards bankruptcy. I'll focus instead on two companies who suffered huge drops wholly unrelated to company performance: Target (NYSE:TGT) and Cola-Cola (NYSE:KO). Let's assume that the investor in question acquired positions in TGT and KO in early 2008, January 2nd to be precise. $1k in each investment would have acquired 20.2 shares of TGT and 16.27 shares of KO.

The 'Rules of Engagement'

Averaging down will occur if the stock drops 15% from initial purchase price without a significant change in fundamentals. In this case, $1000 more will be invested the first day. The next 'strike' for averaging down will be 15% from that price. For example, more TGT would only be purchased if it dropped below $42.08 and more KO would only be purchased if it dropped below $51.92. If more TGT was actually purchased at $40, the next transaction would occur at or below $34. Since this is a long-term investment, all dividends would be re-invested (DRIP).

Target Example Using Purchase Price

Target would have first hit the required threshold on October 6, 2008, when the stock plummeted to $38.35. Assuming the investor had a buy-limit order for $1000 at $42.08, a total of 23.76 shares would have been acquired. The next target would be $35.70; a new buy-limit order should be set immediately considering the volatile environment. Four days later, October 10, 28.01 more shares, and a new buy-limit target of $30.35. On the 18th of November, 32.95 more shares. $25.79 was reached the next day, buying 38.77 more shares. The final target of $21.92 was never reached.

DRIP 1 (Feb 15 -- 14c * 20.2 shares / $52.90 open = .05 shares)

DRIP 2 (May 16 - 14c * 20.25 shares / $54.98 open = .05 shares)

DRIP 3 (Aug 18 - 16c * 20.3 shares / $51.60 open = .06 shares)

DRIP 4 (Nov 18 - 16c * 72.07 shares / $31.55 open = .37 shares)

On 19 November, this hypothetical investor would own 144.2 shares of Target with an average cost-basis of $34.67. Breakeven on the entire investment was reached 7 days later. A total of 68 days between 19 November 2008 and 12 July 2012 had a closing price below cost-basis.

Add in DRIP 5 (Feb 18 2009 - 16c * 144.2 shares / $29.81 open = .77 more shares).

New cost-basis is $34.49, and the basis continues to lower over time. TGT reached a recent-high at $60.26 on 23 December 2010. A graph below from Google Finance shows relevant dividend and 'average down' points. Dotted line represents break-even point, red line represents final buy-limit point (note: TGT hit an all-time high at $70.14 on July 13, 2007; the exercise could be done from this point as well with similar results).

Coca-Cola Example Using Yield

Another common tactic by dividend-growth investors is to buy based upon yield. Everyone does this differently. Some investors analyze yearly, quarterly, or even monthly and decide to buy more if the yield hits a specific target. This is similar to buying on lower-price; however, if a company is performing well dividends can also grow, adding two reasons for adding additional shares.

In the case of Coca-Cola, we'll assume 16.27 shares with an average yield of 2.21%. We'll purchase on an increase in yields equivalent to .5% (i.e. 2.71%, 3.21%, 3.71 %...). This is less frequent initially (change of 20.2%), but requires less and less of a combination of price drops and dividend increases. This approach is more important for an income investor who is searching for yield and has full-faith in a company's operations. This approach also encourages buying companies upon dividend hikes. The initial limit order would be placed at $50.18.

Coca-Cola hiked their dividend to 38c, or an annual yield of 2.56% on February 21. This was still not enough to justify a buy. To achieve a yield of 2.71% at the same annual payout, the price would need to drop to $56.09; time to set a new limit order. On May 9, 2008, 17.83 shares would be purchased, and the new yield target would be 3.21%, or $47.35. October 8, 21.12 shares, new target of 3.71% or $40.97. October 10, 24.41 shares added with a new yield target of 4.21%, or $36.10.

On February 19, 2009 the dividend was increased to 41c, changing our target to $38.95. On March 3, 2009, 25.67 shares would be purchased and the yield target shifted to 4.71%, or $34.82. Despite subsequent dividend hikes, the stock has never hit this yield. The lowest yield reached after May 2009 was on July 2nd, 2010 with an annual rate of 3.52%. Cost basis on the final purchase date of 3 March 2009 was $5000 for 105.3 shares, or $47.48 with an average-cost yield of 3.45%. Including DRIP, cost average would decline further, close to $45. This threshold was passed (and never revisited) in May 2009. A graph below from Google Finance shows the relative purchase points and dividends.

Note: For an interesting exercise, assume the extreme ill-choice of making an investment on Jul 3 1998 for $85.38 at a yield of 0.7%-- hint: averaging down still turns out nicely even after a foolish starting yield).

DECK is Not Dead Yet

The final blow to Dr. Kris's article would be if Deckers Outdoor does make a comeback. Q1-12 resulted in a y/y revenue increase of 20.2%, a y/y gross profit increase of 10.5%, but a y/y profit decrease of 60%. Although margins are deteriorating, this is not, by any means, a dead company. Assuming that the trend continues (profits of only 40% of 2011), DECK will still return EPS of $2.03 in 2012. This represents a current P/E of 22.88, a bit high for myself, but only a 2011 P/E of 9.16 if you believe that Q1-12 was just a hiccup.

DECK's Comeback Price?

Assuming the 15% strategy and the extreme ill-fortune of buying at precisely $117.66 on October 28, 2011, additional shares would have been purchased for $100, $85, $72.25, $61.41, and $52.20, $44.37, with an outstanding limit order for $37.71. DECK has a current cost-basis average of $68.57 (102.08 shares for $7000). Please keep in mind that I don't recommend DECK, but I would find it very ironic if an 'average down' approach actually worked; it's a bit early to call them dead in my opinion. Deck 1-yr chart below (also from Google Finance).

It's All Hindsight? No Definitive Answers?

True, any historical proofs using specific stock or index examples can be written-off as hindsight. For alternate examples, choose the Dow 30 and assume $1000 in each stock starting in 2008. Employ the same strategy. Try the S&P 500 (NYSEARCA:SPY) with 15% drops.

This is a great investment strategy if the underlying investment is solid. The problem does not lie with 'averaging down' being a poor strategy, but rather the initial asset allocation. Averaging down is a very important tool for long-term investors and should be highly regarded. For short-term, speculative traders, I agree that it is often better to simply cut losses than fight the momentum. The problem lies with choosing momentum as a reason to invest in the first place.

Source: Why Averaging Down Can Be A Great Investment Strategy