These are two of the most important techniques one needs to master in their portfolio. They go hand-in-hand, and doing either improperly can lead to significant losses.
I like to bucket my stocks into three categories: safe, semi-safe, and risky.
Safe stocks: I will buy an oversized position in full with my first buy. I have determined this to be a good entry point, and I don't see the stock falling more than 5-8%. Recent examples of this type are KMI, APU, BRK.B and AVB.
Risky stocks: I will start small with the intention of adding if it falls further. These have pulled back, but the drop could still be 20-25% more. I like to use what I call the 2-2-4-7 method on these. Initial buy is 2 units, first add is 2 units, second add is 4 units, and last add is 7 units. The 15-unit total will be my max position size, and you don't want to place the last add too early, so target low with it, around that 20-25% further drop level. The first add will be 1/3 of the way to that point (7-8%), and the second add will be 2/3 of the way to that point (14-16%). Recent examples of this type are TNXP and FEYE.
Semi-safe stocks: The strategy for these falls halfway in between the two buckets above, in two ways. First, I will only target two adds instead of three. I combine the first two buys from the risky bucket so it goes 4-4-7. Second, I see the further drop on these to also be in between the two buckets above, around 12-16%. Again, you target that low with your last add, and that puts your first add halfway there (around 7%). It is important to note that this gives you your 15-unit position down 16%, whereas the risky stocks have only reached 8 units at that point. A recent example of this type would be EXR.
So what's a unit? Well, that's the most important question of all. There are two elements to determining this, and then you need to calculate your adjustment factor.
The first element is how many positions do you want to have. Some people hold five stocks in equal amounts, some hold ten, and some hold forty of varying amounts. I typically hold 20-30 stocks, but some are higher-conviction than others and some are safer than others, so I like to have some half-positions, some double-positions, and from time to time a triple or much larger position. So I will choose to partition my portfolio into 50 positions, so that some can be dry powder, and some stocks can be double or triple positions.
The next step is determining the dollar size of your position. Let's say my portfolio is $100,000. You divide that $100,000 by 50 positions, and you have $2,000 per position. Your higher-conviction stocks would then see $4,000 (double position) or $6,000 (triple position) invested. If your portfolio is smaller, say $20,000, you may choose to only have 10 or 20 positions instead, so that you can still invest $1,000 to $2,000 per position.
Now you have your number of positions, and your dollars per position, but we still haven't defined a unit. This is very important, and is the second element. You don't want your first buy on a risky stock (2 units) to be a full position, or you will have a 7.5X position by the time you get your 15 units. Similarly, you don't want the 15 units to be a full position, or your initial buy will be about a 1/8 position. You can experiment with where you'd like to set this, but I set my 15 units equal to a 3x position. That makes each position 5 units, it puts your initial buy on a risky stock close to a half-position, and it puts your initial buy on a semi-safe stock at 80% of a full position. You would hope that it's a fairly rare occurrence that your picks continue to drop to the max downside you expected, so you shouldn't be hitting those 3x position levels too often.
Using the example above, with $2,000 per position, your first buy on a risky stock would be $800 and your first buy on a semi-safe stock would be $1,600. You then need to determine your adjustment factor. You will find yourself with more conviction on one risky stock vs. another, or on one semi-safe stock vs. another. You might want to apply a 0.75 factor on the lower-conviction ones and a 1.25 factor on the higher-conviction ones. This will allow you to keep the 2-2-4-7 ratio, and the % drops triggering your next add, but you'll invest more in some names than others as you see fit.
If you have one of the smaller portfolios discussed above, and have it partitioned into just 10 or 20 positions, you may want to set your 15 units at a 2X position or limit yourself to just one or two risky stocks to manage your risk.
You then need to determine your conviction level on your safe stocks. Some might be double or triple positions and some might be even larger. This will be influenced by how many stocks you own at the time, how many safe stocks you own vs. semi-safe and risky stocks, how large your semi-safe and risky positions have become, and how many positions you want to keep open as dry powder.
1) Let's say you only like four safe stocks at the moment, but you'd like safe stocks to make up 40% of your portfolio in the current environment. That would require 20 of your 50 positions, so you'd need a 5X position in each. That may seem like a large allocation, but this is exactly what I do most of the time. The beauty of this, is that an 8% gain in one of these safe stocks will be equivalent to a 40% gain in one of your risky single-position-sized names.
2) Let's say we've just seen a correction and you think there's a good chance it's over. You may want to adjust so that you have fewer positions devoted to dry powder, and only 20% of your portfolio devoted to safe stocks. You could buy more semi-safe and risky names, increase your adjustment factor, and/or set your 15 units equal to a 4X or 5X position size rather than the 3X size discussed above.
Selling: that is a topic for another day, however you should consider reducing your position size, as an alternative to selling it in full, as your conviction and risk outlook changes on each position.
Changes in Thesis: you do NOT average down as a matter of course, you only do so if your thesis remains intact. If new news comes along that damages your thesis, or reduces your conviction, you do not continue buying on your pre-determined course. If you have to sell for a loss, do it, and make it back on another name. The golden rule is: if you wouldn't make an initial buy here, don't add.
Impact of a Losing Pick: the point of this exercise is to avoid a bad pick killing your portfolio. You want your stockpicking skills to average out over time. You don't want one bad pick to outweigh six or ten good picks. With this system, a bad pick will have a 3/50ths, or 6%, weight in your portfolio. If a bad pick drops by 40%, the impact to your portfolio would be maxed at a 2.4% loss of total capital (0.06 x 0.40 = 0.024). Even four picks that went horribly wrong would hit you by less than 10%. A lot of people are exposing their portfolio to a lot more downside than that, and that is the purpose of this discussion.
Good luck, and post questions in the comments section below. This is simply my strategy, I'm sure there are plenty of variations out there, and plenty of successful traders and investors who disagree with my methods completely. But for anyone who has been following my trading style, these may be some helpful ideas about how to manage risk between positions.